Transition to New Model Pays Off for Industry Leader

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Adobe Systems' (NASDAQ: ADBE) suite of content creation and publishing software is the unquestionable leader in the industry. However, its old model of receiving one-time payments for hard copies of software is both outdated and holding back revenue growth. As a result, the company has successfully transformed its product to software as a service by utilizing the cloud. This transformation paves the way for future growth.

Industry standard

When you think of web design software -- you think of Adobe Dreamweaver. When you think of photo editing software -- you think of Adobe Photoshop. And when you think of document management -- you think of Adobe Acrobat. These programs, along with Illustrator, InDesign, Soundbooth, Flash Player, After Effects, and a host of other high-quality creative software programs are responsible for Adobe's long history of profitability and consistently-high margins.

Not only are Adobe's suite of products the highest quality in the industry, they are also the standard tools used in education. For instance, a class that uses photo editing software will teach its students to use Photoshop -- since that is what they will use in the real world. So the network effect -- the advantage gained by having such widespread adoption -- has paid dividends for Adobe through the years.

A necessary transition

Despite having a superior product and a large user base, Adobe is still vulnerable to competition. Adobe's model of selling packaged software caused long upgrade cycles -- you have to make a major update in order to distribute a new version. As a result, one user might have one version of Photoshop while another might have a different version installed. This creates inconsistency across the user base in terms of features and usability.

In addition, competitors like Microsoft's  Expression Studio and Apple's  Aperture were priced lower and therefore more appealing to users with less sophisticated needs. Luckily, Microsoft recently deprecated Expression Studio and Apple's software is not nearly as sophisticated or robust as Adobe's product -- but it still poses a challenge for acquiring users with less sophisticated needs.

In order to rectify its shortcomings, Adobe has committed to a fully-online distribution of its entire Creative Suite of products. As a result of moving its product to the cloud, Adobe can ensure timely updates for all users in addition to providing a lower entry price for new customers (customers will now pay a monthly fee).

So far, the transition has worked out much better than expected. Although there has been a slight dip in revenue due to the transition, recurring revenue is becoming a much larger portion of overall revenue.

Adobe's Digital Media segment, which includes its creative products as well as document services products (e.g., Acrobat Reader), accounts for roughly 70% of total revenue.

As the transition to the software as a service model got underway, Adobe's recurring revenue started to skyrocket. In the first quarter of 2012, recurring revenue was non-existent. By the first quarter of 2012, it accounted for nearly 11% of revenue.

<img alt="" src="" />

In addition, the number of subscribers is expected to more than double by the end of fiscal 2013. Total annualized recurring revenue is projected to be $800 million by the end of fiscal 2013 -- or about 17% of total revenue.

A transition with precedence

Adobe is not the first company to see the promise in moving to the cloud. Intuit (NASDAQ: INTU) was an early adopter of cloud technology. When it switched over its popular QuickBooks and TurboTax software from in-the-box to on the cloud, sales and recurring revenue soared after an initial decline in revenue. Most users evidently prefer to pay a monthly fee than to pay the huge upfront cost. Intuit took a huge risk by being an early adopter of cloud technology, but the gamble paid off. Now that the concept has proved successful, Adobe can simply take the Intuit model and apply it to its own software with substantially fewer unknowns than when Intuit made the switch. As a result, investors should expect Adobe's success to be similar to that of Intuit.

The shift to cloud computing will likely position Adobe for long-term success as the entire sector moves to support the technology. For instance, EMC (NYSE: EMC) -- the leader in network storage capacity -- is undergoing a shift toward cloud computing in order to keep up with its more nimble competitors. However, EMC may ultimately lose out in the cloud computing race; as the technology becomes even less expensive and more accessible, more companies will be able to maintain their own cloud infrastructure. But, while network infrastructure companies like EMC lose out from cheaper cloud technology, users of the technology -- such as Adobe and Intuit -- win.

Bottom line

Not only is Adobe positioning itself for growth by switching to a more flexible distribution model, it is also gaining a significant recurring revenue stream that will serve it well when times get tough. Expect shareholders to be rewarded as the transition reaches completion over the next few months.

Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems and Apple. The Motley Fool owns shares of Apple and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus