Adobe: A Software Giant from the 80s

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John Warnock and Charles “Chuck” Geschke, who met each other while working for Xerox, co-founded Adobe in 1982. John was leading a team at Xerox to build InterPress, a protocol for Xerox printers and became disillusioned as Xerox showed little interest in going to market with his product: “We sold InterPress throughout the Xerox organization for two years. They said, “Oh, we love it. We’ll make it a standard. We are going to put the locks on it and wait until all of our printers can do this before we release it.” Chuck and I found this totally unacceptable and realized, “That will never happen in our lifetime.” The only way to make standards is to get them out and just compete. I went into Chuck’s office one day and said, “Chuck, we can stay at a very cushy, wonderful job here. Or we could try to get something done.”

Chuck and John decided to leave their cushy jobs to start Adobe, which was named after a creek in Los Altos (near Chuck’s house). They developed PostScript, the device-independent programming language between PC and printer that could describe text, graphics, and images on one page. PostScript, along with the Apple Macintosh graphical user interface and laser printers, launched the desktop publishing industry in the 80s. Adobe found the product market fit right away and kept growing revenues at more than triple digit rates in the first six years since its founding. Apple (basically another Steve Jobs masterstroke) bought ~15% stake in Adobe in November 1984 for $2.5 Mn. Adobe went public in 1986, and when Apple decided to sell its stake in 1989 (alas, Jobs wasn’t there anymore), its stake was worth ~$84 Mn, a cool ~34x of its initial investment or ~102% CAGR over ~5 years. Apple, however, “missed out” on ~30% CAGR over almost four decades! I’m sure nobody is complaining at Apple, but why did Apple sell?

In 1989, although Adobe had 30 customers, Apple accounted for 29% of Adobe’s revenue and decided to work on a rival product of PostScript. Given the former partners were becoming potential rivals, Apple sold its Adobe stake. While Adobe’s sales decelerated dramatically in 1989, Adobe also laid out the groundwork to diversify its products. By the late 80s, Adobe launched two more products that went onto define their categories: Illustrator (vector-based editing software) and Photoshop (pixel-based editing software). While Illustrator was developed organically, Adobe licensed the Photoshop software in 1988 and eventually bought it outright for $34.5 mn in 1995. In 1991, Adobe launched Adobe Premiere (video editing software). The product velocity didn’t even stop there and in 1993, Adobe launched Portable Document Format (PDF).

The history of PDF is quite interesting. While PDF is by far the most pervasive digital document format today, John mentioned, “When Acrobat was announced, the world didn’t get it. They didn’t understand how important sending documents around electronically was going to be.” In fact, Adobe’s board wanted to kill the project, but John had a different vision in mind, “What industries badly need is a universal way to communicate documents across a wide variety of machine configurations, operating systems and communication networks. These documents should be viewable on any display and should be printable on any modern printers. If this problem can be solved, then the fundamental way people work will change.”

It wasn’t the private sector which internalized the value of PDF, but IRS which really made good use of PDF in digitizing its tax forms. In early 90s, IRS used to send mails to 110 million individuals during tax filing season. Given the complexity of tax code, these forms came with wide variety of exceptions for both businesses and individual taxpayers. By 1994, IRS started distributing tax forms in PDF format which accelerated the adoption curve.

Two things stood out to me while studying the first decade of Adobe: a) the product velocity of that early decade is nothing short of extraordinary. Photoshop, Illustrator, PDF…these are still household names even three decades later. There aren’t perhaps too many three-decade old software brands still dominating the market. Considering the natural obsolescence risk tech industry generally grapples with, it is a remarkable feat. It is likely that these software brands (I know I’m using the word “brand” loosely but still opting for it because while the code behind the software didn’t remain the same over the decades, brands such as Photoshop became verb) today generate vast majority of Adobe’s Free Cash Flow (FCF) today; and b) the persistence and resilience of the founders even at the face of lack of immediate traction of new software or losing a customer that contributes 30% of revenue really drilled down the paramount importance of founders in fast paced industry such as tech, especially in the early years.

Source: Adobe’s SEC Filings, MBI Deep Dives

Speaking about the importance of founders, unfortunately they can also hold back their businesses at times. After growing like weed for more than a decade after founding, Adobe hit a rough patch from mid 90s to early 2000s despite the rise of web and tech bubble that ensued at that time. Knowledge at Wharton mentioned the following, “Yet that vision of what is technically and aesthetically “right” has also blinded the company to some of the major shifts in technology. During the rise of the web, Adobe sat on the sidelines longer than most companies partly because, as Warnock characterizes it, “early versions of HTML — from a design point of view — were awful.” From 1996 to 2002, Adobe grew its revenue at less than 7% CAGR. Warnock retired from CEO in 2000 and then from CTO in 2001. He, along with Chuck, co-chaired the board till 2017. After Warnock, Bruce Chizen became CEO who came to Adobe thanks to the acquisition of Aldus in 1994. During his tenure, Chizen himself made a significant acquisition: Macromedia for ~$3.5 Bn in 2005 and he later mentioned that Adobe was primarily acquiring Macromedia to get Flash. Then in 2007, Shantanu Narayen became CEO who is still leading the company today.

While Adobe somewhat got out of the slump it found itself during the rise of internet, sales continued to be lumpy and much more volatile in sympathy with the broader macro environment. During the global financial crisis, sales fell precipitously by 18% in 2009 and even during post-tech bubble recession, Adobe’s sales went down two consecutive years. Adobe experienced more pronounced volatility than most software businesses at that time because Adobe had only 19% recurring revenue in 2011, and the rest of the revenue was mostly generated by selling perpetual licenses (customers pay once and can use the software indefinitely). Narayen wanted to dampen this revenue volatility and wished to make the business more predictable and stable even in difficult macro periods. As a result, Adobe announced to switch to subscription model in 2011 and while for a couple of years, they supported both perpetual licenses and subscription model, they fully deployed resources to subscription business by May 2013.

Source: Adobe’s SEC Filings, MBI Deep Dives

By any measure, the decision to move to subscription model has been a resounding success. But it was far from an obvious decision at that time. Apart from dampening the volatility of the business, there were other important reasons behind Adobe’s change to subscription model. Under the perpetual licensing model, the number of units shipped was about three million for a long time, and the only way they could increase sales is by raising prices or moving customers to upgrade products. That’s exactly what Adobe was doing; for example, the perpetual license for Illustrator used to cost $399 in 2004, $499 in 2005, and $599 in 2008. Even though Adobe clearly had pricing power, the management perhaps suspected such a strategy has an expiry date, especially in the zero marginal cost of software world. Moreover, Adobe suspected there was a much bigger market out there which it was not serving as these customers weren’t ready to pay the upfront cost of the perpetual model. In an interview with McKinsey, Adobe management shared how they managed this stressful period:

“In November 2011, we announced our intentions to Wall Street—it was a full day of briefings, with financial analysts focused on communicating the strategy, ramifications, and financial expectations. One aspect of the strategy was that we were being more aggressive in shifting our Creative Suite (CS) business to the Creative Cloud. Another aspect was that we were doubling down on our cloud-based digital-marketing business. We decided to shift $200 million in operating expenses toward these high-growth opportunities. After we announced our plans, the stock price dropped by 6 percent, which actually was less than we had anticipated. It fully recovered within three months. We launched Creative Cloud and Creative Suite 6 (CS6), under the traditional perpetual-licensing model, in May 2012. So there was a period in which we were doing things in parallel. But after about a year, we felt ready to step on the accelerator and move everything to the cloud. In May 2013, we said we would no longer add new capabilities to the CS line, although we would continue to sell and support CS6.

We gave them “markers”—for instance, we said we were going to reach 4 million subscribers in 2015 and build up ARR. As the switch-over progressed, toward the end of 2013, investors became intrigued and started asking about longer-term objectives. So we projected the compound annual growth rate and earnings per share out three years and shared those metrics.

This was new for us; previously we had only given guidance one year out. The point is, we were transparent. We over-communicated. When we did that, and when Wall Street saw the traction we were getting with the initial release, the stock started to move.”

After being stuck at three million units under the perpetual licensing model, Adobe blew past its guidance of 4 million subscribers for 2015. Adobe exited 2015 fiscal year with more than 6 million subscribers. In my estimates, Adobe had more than 24 million subscribers to its Digital Media business (which is mostly Creative Cloud) in 2021, implying they indeed served just a fraction of the market under their old business model. Moreover, even though operating margin took an immediate hit following the switch to subscription as it went down from ~27% in 2012 to ~10% in 2014, it quickly recovered to ~26% in 2016, and in 2021, the operating margin (remember, this is GAAP, so I’m not ignoring SBC here) reached an envious 37%.

Source: Adobe’s SEC Filings, MBI Deep Dives

What made this transition perhaps even more impressive is not only Adobe continued its dominance in creative cloud but also expanded its business to a new segment over the last decade: Experience Cloud which Adobe got into via its acquisition of Omniture in 2009 for $1.8 Bn. Then in 2012, Adobe launched Adobe Marketing Cloud which was later renamed to be “Adobe Experience Cloud”.

Now that we have a good grasp on the history of Adobe, let’s get into the present in more detail.

Section 1 Adobe’s Economics: I discussed Digital Media (including Creative Cloud, and Document Cloud), and Digital Experience segments and their economics and cost structure by segment.

Section 2 Total Addressable Market: Adobe’s Total Addressable Market (TAM) by segment as well as its penetration in these segments was highlighted in this section.

Section 3 Competitive Dynamics: Adobe’s competitive dynamics varies greatly depending on the segment. While Adobe absolutely dominates Digital Media segment today, Digital Experience’s dynamic is somewhat different. The durability of Digital Media’s “monopoly” is the focus on this section, but I also briefly touched on Document Cloud and Digital Experience as well.

Section 4 Capital Allocation and Incentives: Adobe’s capital allocation history under Shantanu Narayen (Adobe’s CEO since 2007) and management incentives are discussed in this section.

Section 5 Valuation and Model Assumptions: Model/implied expectations are discussed here.

Section 6 Final Words: Concluding remarks on Adobe, and disclosure of my overall portfolio.

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