Adobe Jumps Off A Cliff, Leaves Parachute Behind

| About: Adobe Systems (ADBE)

Adobe (NASDAQ:ADBE) announced Monday that it was moving all its professional graphics arts users from a package software purchase model to a subscription model. This is certainly a bold - if not risky - move, but so far I can't tell if it's a sign of strength or weakness.

Package software is how Adobe was started - as was true for nearly all 20th century software companies. The company would develop a major new release, sell it as a product, provide free bug fixes for a while and then start over. Adobe was unusual - or perhaps a trend-setter - in that it never tended to give much of a discount for previous owners to buy the new copy. Adobe also got in the habit of bundling packages in "suites": for example, I once was a Dreamweaver user, but the suite pricing forced me to find another alternative (currently the open source SeaMonkey) when an OS upgrade rendered my 8-year-old copy of Dreamweaver obsolete.

Under the new plan, the flagship "Creative Suite" will become "Creative Cloud." Fortunately for users, the "cloud" term is somewhat misleading: it's not a Cloud in the sense of Google Docs or webmail - with all the apps running in the cloud - because the latency of such interactions would make Photoshop or Illustrator unusable. Instead, Creative Cloud is more like the Apple model with apps on the PC and document synchronization between a PC (or other device) and Adobe's servers. In the 1990s, we called this groupware, although obviously things have gotten better since then.

The big difference is that instead of paying for releases, Adobe wants users to pay for subscriptions. The migration will be enforced by orphaning the old products, which gradually will become obsolete and irrelevant.

Usually when you make such a dramatic transition, you run the two business models in parallel. In Monday's presentation, Adobe's CFO Mark Garrett said that the subscriptions have topped 500,000. At $50/month, that's $300 million a year; with annual revenues of $4.5 billion, that's meaningful but not overwhelming. Their 2012 10-K stated:

We continue to derive the majority of our revenue from perpetual licenses. However, our subscription revenue, as a percentage of total revenue, has increased to 15% in fiscal 2012 from approximately 11% and 10% in fiscal 2011 and fiscal 2010, respectively, as we transition more of our business to a subscription-based model.

So the ability to make this shift suggests strong pricing power by Adobe. As Garrett said:

So our end goal, from my perspective, of faster revenue growth for this business and more recurring revenue is now even clearer than it was before, and these announcements today really reinforce that.

Garrett said that beyond the core audience or beyond full-time "creative professionals," it's targeting three other groups: marketing staff at small/medium businesses, SOHO photographers/hobbyists, and education.

All of these are problematic. When I ran a small business, we wouldn't spend $600/year/seat for anything, nor would I as an individual. Even at a reduced pricing of $360/year, the price seems too rich for the education market ("one of our most important vertical markets" according to Garrett).

Various commentators have questioned this pricing model, including Karl Denninger on Seeking Alpha and Lori Grunin of CNET. People are grumbling, but of course nobody likes a price increase - so the real question of pricing power is whether customers have any realistic alternative. (Adobe's 89% gross margins suggests most of their customers are stuck).

On the other hand, the shift to seek revenue growth through a new business model - rather than creating new products - could be seen as a sign of weakness. It takes me back to my second software more than 30 years ago, developing minicomputer simulation tools. In our case, we used a monthly (or annual) service contracts when we were unable to provide meaningful upgrades that people would pay for.

The new pricing model does not appear (yet) to cover low-end consumer products such as Photoshop Elements. My guess (just a guess) is that if the professionals cooperate with the subscription model, Adobe will attempt to shift consumers to the subscription model within 3 years.

One thing going for Adobe is that most of its rivals among professional software companies have pulled back or (as with Aldus and Altsys) been bought up. Open source alternatives are not viable competitors to the Creative Suite apps. However, Adobe faces challenges in the low-end consumer market from App Store apps that sell for $30 or less as new customers seek convenient, affordable alternatives.