Adobe Moves Software Out of the Box and Into the Cloud

Updated May 6, 2013, 7:44 p.m. ET

Adobe Moves Software Out of the Box and Into the Cloud

By STEVEN D. JONES

Adobe Systems Inc., ADBE -1.11% the maker of Photoshop, Illustrator and other design tools, is getting out of the packaged-software business and will sell its biggest products only as online services.

The decision announced Monday by one of the largest software publishers underscores how the industry is adjusting to changing consumer tastes. People are buying fewer boxes of software—just as they aren’t buying as many CDs, movies and books in stores—and turning to Internet-based cloud services.

Adobe, which began selling its software in stores in 1987, will no longer offer new versions of its creative software at retailers such as Staples or allow people to download digital copies to their computers.The move is a risk for a company that makes most of its $4.1 billion in annual revenue from licensed and packaged software. Adobe will have to convince its customers—mainly creative professionals such as illustrators, photographers and publishers—to use the software through a subscription-based service called Adobe Creative Cloud that it launched a year ago. The company maintains the software on its servers and continuously updates it.

Adobe doesn’t plan future packaged versions beyond Creative Suite 6.0, its current set of design software, although it will continue selling and supporting that product.

Customer benefits include possible savings on internal labor costs, while Adobe will enjoy a smoother flow of revenue rather than big swings when new products hit the market.

Shantanu Narayen, Adobe’s chief executive, said creative professionals prefer features of the online service, including the fact that it is constantly updated with new features. The company’s subscription pricing also “scales the offering” from individual freelancers to the biggest enterprises.

“We wanted to align the company with the future of the creative process,” Mr. Narayen said.

Other companies that have added online options beyond shrink-wrapped programs include Microsoft Corp., MSFT +0.78% with offerings such as its free Outlook.com email service. Design and engineering-software maker Autodesk Inc. ADSK +0.20%launched a cloud service two years ago and now earns nearly 40% of revenue from subscriptions rather than sales of packaged products.

But Adobe’s decision to focus primarily on the cloud stands out. Both Microsoft and Autodesk continue to sell packaged products and digital downloads of their biggest products.

Ending the annual update cycle required for a packaged software business in favor of online delivery frees Adobe engineers “to put innovation in our members’ hands at a much faster pace,” said David Wadhwani, Adobe’s general manager for digital media.It also frees the company of the packaging and distribution expense to focus on subscribers, which now total more than 500,000 and are growing at about 12,000 a week. The company expects to have four million subscribers by the end of fiscal 2015.

Adobe’s embrace of subscription cloud services is the latest move in a two-year transformation from distributing desktop software and content reliant on its Flash streaming media to one focused on portable software that runs online rather than inside a device.

In the process, the San Jose, Calif., company ended development of mobile Flash, trimmed about 750 jobs and adopted a collection of portable media technologies backed by Apple Inc. AAPL +2.38% and others.

As part of the cloud strategy, Adobe is adding the letters CC to popular products such as Photoshop CC, to make clear they are integral to the Creative Cloud. It also plans to make several improvements to store, synchronize and share content inside its cloud along with discount pricing to appeal to users of its packaged software and newcomers as well.

Adobe is offering existing Creative Suite customers discounts of about 40% on the first year of service. After that an annual contract costs $50 a month for individuals. Corporate subscriptions include cloud storage and administrative tools and cost $70 a month per user. Off the shelf, the standard design edition of Creative Suite 6.0 retails for $1,299.

Adobe’s Acrobat document reading software will still be available outside the Creative Cloud as an individual licensed product. Subscriptions to single applications, such as Photoshop, are available for $20 a month.

At Vertigo Software Inc. in Point Richmond, Calif., five of the 13 staff designers have switched to Creative Cloud and the rest will soon follow, said Tony Sokolowski, vice president of design. Having all Adobe tools at everyone’s fingertips is a plus, he said, although the storage, sharing and editing features of the cloud service need improvement.

He estimates that his company over time will pay more for software through the subscription service than buying packaged programs. “The regular monthly cost is easier for budgeting, even if it will cost us more in the long term,” he said.

An Adobe spokesman said cloud subscribers are receiving additional value such as storage and collaboration not available with the packaged products.

For suppliers, one challenge of shifting to subscriptions is that revenue that once arrived in a lump sum is booked gradually, while deferred revenue is added to their balance sheets. So rising demand for online subscriptions can translate into falling earnings in the early stage of the transition.

Adobe said that net profit fell 65% in its fiscal first quarter ending in February one year after launching Creative Cloud in April 2012, as the company invested in creating and marketing the cloud.

During the period, Adobe added 153,000 Creative Cloud subscribers, which boosted annual recurring revenue by $80 million to $233 million.

But because most of those sales will be booked in future quarters, cash revenue in the first quarter actually declined 3.5% to slightly more than $1 billion.

Analysts polled by Thomson Reuters expect Adobe to earn net profit of $311 million on revenue of $4.1 billion in fiscal 2013 ending in November. That compares with net profit of $832 million last year on nearly the same revenue, after adjusting for discontinued operations. Analysts expect both revenue and net profit to reaccelerate in 2014 and beyond.

Brad Zelnick, an analyst at Macquarie, estimates that recurring subscription revenue could swell to $697 million by the end of the year.

“The important point is the cost of renewing that subscriber is less than the cost of acquiring the customer in the first place,” Mr. Zelnick said. “You see efficiency from the direct relationship with the customer compared to the discrete software sale in the old business model.”

Beyond accounting changes, companies that grew up under the industry’s original model have to learn new skills and practices associated with service companies rather than just product companies.

“It is no longer about the number of units sold, but the number of subscription customers and the quality of that relationship,” said Brian Bell, chief marketing officer for Zuora Inc., which helps companies establish subscription businesses. “That’s a big shift for an enterprise software company.”

Adobe announced the move to focus on cloud services at its annual user conference in Los Angeles. On Monday, its shares dropped 1.1% to $46.49. Adobe’s stock is up 41% since it launched Creative Cloud in April 2012.