Adobe changes business model to cloud-based subscription

Adobe's entry into cloud computing with Creative Cloud is a welcome development for consumers but the Street is less sure.

(Photo: Maciej Frolow/Getty Images)

Among the newest members to join “club cloud” is San Jose, Calif.-based Adobe Systems Inc. The company has officially moved its market leading graphic design and productivity offerings to the cloud with the May launch of Creative Cloud. The move constitutes a major change in business model, but the Street isn’t entirely convinced it’s the right one.

If it’s not the right one, it’s certainly an exciting and welcome one for consumers who have for years had to put up with very expensive products nevertheless out of the reach of many would-be users.  (Many people know a person or two running a version of Photoshop three years out of date—if the copy wasn’t pirated to begin with.) What Creative Cloud does is allow consumers to pay a monthly fee to subscribe to various Creative Suite applications like Photoshop, Illustrator, Dreamweaver, etc. At $30- $75 per month, which includes other benefits like syncing, sharing and cloud storage, this instantly makes such apps affordable for more than just professional designers employed by enterprise or big media and advertising firms.

But as with any initiative there has to be something in it for the business. The answer may lie in the long-run growth prospects for Adobe’s two main lines of business—products and subscriptions. Over the last 10 years revenue growth in the former has averaged 11.87%. In subscriptions that number jumps to 170.9% although admittedly this data goes back only to 2008. But tellingly, it looks like a subscription model is also more recession proof. Following the depressing effect of the 2008 financial crash, Adobe’s 2009 revenues for its products dropped 20%, but for subscriptions grew 77.7%. This would seem to correlate with typical consumer psychology insofar as big ticket purchases get whacked first while smaller, incremental costs are more likely to survive the knife. (Call it layaway for the professional class. Discount retail has come back to layaway in resounding fashion over the last two years because of similar economic pressures.)

Adobe’s official reason is of course more politic. It says it moved to a cloud-based subscription model because users were “screaming” for the ability to publish direct to tablets like the iPad and to publish web sites. As Scott Morris, senior director of product marketing, puts it, “They’re really frustrated that that they can’t get that beautiful magazine they can design to the iPad, which is perfect for an interactive magazine experience.” Ironically, the ability to publish to a tablet using Creative Cloud isn’t yet available, but Morris says it will be this fall. (Tablet publishing is handled separately via Adobe’s Digital Publishing Suite.)

In the meantime, Adobe will just have to content itself with the steady, rather than periodic, stream of revenue afforded by its new model. “From a business perspective for us what this means is customers are constantly engaged with Adobe. It’s a very attractive price point. But over the course of time it’s actually more attractive for Adobe because of higher lifetime value from our customers—they’re paying us a little bit each month … and we ultimately do better financially over the long run.”

Right now this is the sticking point with some investors who, according to one analyst, “don’t understand” Adobe’s new model. Mark Moerdler, senior analyst at Bernstein Research*, says there are some on the Street who mistakenly believe Adobe is abandoning traditional distribution in favour of software-as-a-service and that this is too disruptive to its economics. But, says Moerdler, “they’re not modeling the upside that occurs in the following year after people move to a subscription model. Because there’s a revenue lift—you get less revenue this year because you’re getting it over time but starting next year and beyond you get more because it’s now a recurring revenue stream.”

Adobe isn’t abandoning its retail and corporate reseller channels either; subscriptions to Creative Cloud will be sold via point-of-sale activation cards at places like Best Buy and Staples. For the corporate resellers like CDW and Softchoice, volume licensing will continue, but Morris says a special version of Creative Cloud for this market isn’t due out until the fall.

Analyst opinion remains mixed although Moerdler rates the stock an outperform. Since June 2011, Adobe’s return is down about 10%, compared to the Nasdaq which is up 3%. One other worrying element on its Q2 income statement is its cost of revenue for subscriptions which, at 34%, is substantially higher than the same cost for products at 4.6%. As a measure of profitability, investors will want to see that number improve if the efficiency gains of going cloud are to mean anything in terms of improved margins. However, Moerdler attributes the discrepancy primarily to Adobe’s existing Omniture analytics business which accounts for most of the subscription revenue. But he does say some is indeed the short-term expense of building out a cloud infrastructure.

From conception to launch, Adobe made its move to the cloud very quickly. Morris says that while there were some discussions a few years ago, the company didn’t get “serious” and put together a model until October 2011. A team of engineers was immediately assembled and eight months later Creative Cloud was ready to launch. He says they were able to do it so quickly because most of the applications and the cloud’s web hosting feature already existed, touch applications for tablets were already being worked on, and value-adds such as cloud-based access to fonts were ready via the October 2011 acquisition of Typekit.

While the stock price is at this time currently down about 13% from last year, Adobe appears to have generated at least one key win with its shift in model—new customers. Morris says that about a third of buyers coming to Creative Cloud are clients such as small business marketers who are “new to Adobe.”

Adobe is doing this without any additional marketing push and instead relying on a word-of-mouth “halo effect.” But that might only get you so far. As the saying goes, you have to spend money to make money. Says Morris, “Over time one of our strategic objectives is to grow our customer base and not just keep selling upgrades to the existing customers. … We will probably change our marketing over time to specifically focus on those folks to accelerate getting those small business marketers in.”

*Note: Bernstein Research is owned by Sanford C. Bernstein & Co., which holds a position in Adobe.