In the broad business-model shift that has swept through the software industry over the past decade, has any large company in that field — let alone a publicly held one — pulled off the transition as speedily, thoroughly, and successfully as has Adobe Systems?
Almost surely not.
In November 2011, the company announced its intention to move away from selling its digital-media creative and design tools — which represented about half of its revenue base — in the form of so-called “boxed” (or perpetual-license) software. Instead of paying hundreds of dollars up front and getting product updates every 18 to 20 months, customers would be able to buy a subscription at a far lower price point to get access to cloud-based tools that would be updated as often as monthly.
Adobe’s CFO since 2007, Mark Garrett, had no doubt that the change, which many other software companies had made or were in the process of making, was necessary. That didn’t mean he wasn’t nervous about telling stock analysts and big investors about it, because making the move meant that the company’s financial results would have to get worse before they got better.
“Take Photoshop, for example,” Garrett says. “It’s a product that cost, call it, $700 up front, and we recognized that revenue then. Now we were going to offer Photoshop and Lightroom bundled together in the cloud for $10 a month. It was scary getting up in front of Wall Street and telling them that revenue and earnings were going to nosedive for a few years, ‘but oh by the way, you should still invest in Adobe for these reasons.’ It was the right thing to do, but it was a hard story to create and a hard pill for us to swallow.”
Indeed, Adobe’s net earnings fell for the next three years, from $833 million in 2011 to $268 million in 2014, as the company sold less and less boxed software and converted more and more customers to the recurring-revenue model. In May of 2013, even as earnings were continuing to fall, Adobe announced that there would be no more new releases of its perpetual Creative Suite, and the following year it began phasing out sales of the product.
The company’s turnaround, which had been building for some time, finally showed up in its P&L in the first half of this year, when net income almost doubled (to $233 million) from the same period in 2014 ($136 million). Adobe expects to end 2015 with $3 billion in annual recurring revenue. “Think of it as a waterfall,” Garrett says. “We have more and more people paying us every month, as opposed to the old model where they paid at random times and we recognized all the revenue up front.”
The results are justifying something Garrett had told Wall Street back in November 2011: “The faster earnings fall, the better off we are as a company and the better off you are as an investors, because millions of people paying us every single month is very compelling from a revenue perspective.”
Adobe had licensed its perpetual Creative Suite to about 13 million customers and expects to exit fiscal-year 2015 with approximately 5.9 million Creative Cloud subscriptions. As of the fiscal year’s second quarter, the number of subscriptions was 4.6 million, more than 20% of which were new customers of the company’s tools for creative professionals.
In a fundamental respect, what Adobe did was nothing other than what many software companies had done and others were then doing as well. On the other hand, there is a healthy dose of uniqueness to its story.
“If you think about a software company of ‘scale’ — defining that as having at least $1 billion in revenue — we’ve looked at all of them, and none has moved from a perpetual model to a recurring-revenue model in such a short time,” says Garrett. “Or alternately, what software company has created more than a billion dollars in recurring revenue in less than two years, as we did? Again, it is easy enough to look around and see that no one else has done it.”
Why the Change?
It’s quite common today for companies to tell a story of near tragedy during the Great Recession followed by a gut-wrenching but heroic revival effort that beat the odds. Adobe fits that mold.
Until 2008, the company was doing well with its perpetual model, but when the recession blew in, Adobe, stuck without any recurring revenue, was hit hard as consumers and businesses alike made fewer big purchases.
At the same time, the company began to realize that the number of creative professionals wasn’t growing very fast. And the existing pool was inclined to skip new versions of Adobe’s software, because the existing versions continued to work well for long periods of time. “It was not a recipe for long-term growth,” says Garrett, “and it created a real sense of urgency. The business was going to fall flat if we didn’t do something.”
The company’s finance and strategy teams looked hard at companies that had recurring revenue streams and how they were performing during the economic downturn. “It was a huge wake-up call for us,” the CFO says. “And we as a finance team needed to help the business understand the problem.”
Adobe tested making its creative tools available via subscription in Australia and was encouraged by the number of customers that switched and by the number of new ones picked up. But it sensed that for the effort to succeed broadly, it would have to do more than simply offer a subscription option.
“The key was not just transforming the price and how people paid us,” Garrett says. “The analogy I use is that we didn’t want to have an offering where they could decide whether to buy the car or lease it. That’s just math. We needed a product that was materially different, a whole new product.”
The product that was developed, Creative Cloud, was designed to leverage the cloud: to store content, to work seamlessly across both desktop and mobile devices, to enable collaboration, and to allow additional services to be built on top.
The Need for Speed
Improving the product and user experience was among several key reasons why Adobe was able to accomplish the business-model transformation more quickly than expected. “We did a lot of things right,” says Garrett.
Also crucial was a commitment to transparency. “We erred on the side of overcommunicating,” he says. “I can’t tell you how many internal meetings we had, how many partner meetings, how many investor meetings, to explain what was going on. We redefined every part of our value chain, from go-to-market to our IT organization to our financials, and along the way we needed to keep employees, investors, and customers right there with us.”
Adobe’s performance was actually brightening well before this year, even if it wasn’t showing up in the income statement. Other metrics the company began tracking after switching to the subscription model gave Wall Street a new story. Two of the most important were average revenue per user per month, or ARPU; and annualized recurring revenue (ARR), which is the number of subscribers times ARPU times 12, plus the value of Creative Cloud enterprise term license agreements — volume-based deals with large enterprise customers that terminate after a set time, often three years, and are not included in the ARPU calculation — for the subsequent four quarters.
Other metrics, common to software subscription businesses, included deferred revenue (contracted and billed future revenue that will move to the income statement as reported revenue in the next four quarters) and unbilled backlog (contracted but not billed revenue beyond a year’s time).
To say that the company’s story resonated on Wall Street is something of an understatement. Its stock, which had been performing unevenly before the November 2011 announcement and was trading far below its high-water mark, began rising almost immediately, albeit slowly. The price improvement began to gather momentum starting in late 2012 and never looked back. The stock surpassed its all-time high in May 2015 and at press time was trading at almost $87, compared with less than $30 three and a half years earlier — far outpacing the gains of both the S&P 500 and the Dow Jones Industrial Average during that time.
But the most important action Adobe took to stimulate greater adoption of the subscription model was the decision to pull the plug on the perpetual offering, according to Garrett. “If we hadn’t done that it might have taken 10 or 15 years to make this happen, because customers would have bought what they were comfortable with. We had some resistance from them all along.”
Garrett calls it a “burn the boats” mentality, referring to pre-industrial conquerors who burned their ships after a conquest so that the crew couldn’t leave. “The idea is, go all in on your strategy,” he says. “We had a subscription offering that we felt was better than the perpetual offering, so we burned the boats.”
The decision was another factor that helped out on Wall Street, which “doesn’t like long transitions or uncertainty, and having the old model still in place created uncertainty.”
Now that the business-model transition has been executed, and it remains the case that, as Garrett points out, the worldwide population of creative professionals is not rising at breakneck speed, how will Adobe continue to grow?
There are three main components to that, Garrett says. First, there are many millions of software customers that have not yet converted to the Creative Cloud. Second is attracting new users; somebody for whom photography was a mere hobby, for example, may be more willing to pay $9.99 a month for the cloud-based Photoshop than the $700 they had to pay up front to get it before. (The full Creative Cloud is $49.99 monthly.)
The third path to growth is driving higher ARPU per customer by selling add-on services like Adobe Stock, a stock-content marketplace that the company picked up with its acquisition of Fotolia in January 2015.
Aside from the creative segment, Adobe’s other businesses, which also are cloud-based, are document services (the Acrobat product line) and digital marketing automation and analytics (the Omniture platform, which the company acquired in 2009). Each of those is about half the size of the creative business.
Customers can leverage all three capabilities in conjunction with one another. “Everybody is trying to move more of their business online, and everything we do is to help our customers optimize their businesses online,” says Garrett. “We do that at what we call the intersection of art and science, or you could also think of it as the intersection of content creation and data.”