Adobe Inc. and the Power of Old School Software Economics

Take-Away 1: Adobe Inc. is a good example of many of the strengths of traditional software economics. It has evolved and expanded over decades to become a full suite of creative tools. It is now trying to expand from creative tools to operating tools.

Take-Away 2: However, purely digital companies need to protect their attractive economics with competitive advantages. Adobe has used standardization network effects and some switching costs. If its profits have come from software economics, its competitive strengths have come from connectivity.

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I really like Adobe Inc.

It’s one of few purely digital companies that has been around and thriving since the early days of the PC. The evolution of its business model has mirrored the development of the internet. Plus, it’s a software animal.

I was going through Adobe’s 10-k again. And I thought it had some good examples of the strengths of digital economics, in particular:

• Zero marginal production costs, low distribution costs and the fast and low-cost scalability of digital goods.
• Freemium pricing and versioning.
• Standardization network effects.
• Subscriptions and bundling.

It’s also a nice contrast to all my focus on platform business models. Adobe is a very successful company that is mostly a pipeline, a traditional software company.

An Introduction to Adobe Inc.

Adobe was founded in a garage in Los Altos, California in December 1982 – by John Warnock and Charles Geschke. Geschke was a ten year veteran of Xerox’s Palo Alto Research Park and Warnock had worked for him since 1978.

At Xerox Park, they had developed a postscript page description language that could describe forms as typefaces. Basically, it was software that let you print what you saw on the screen. Unable to convince management of its value, they left to found Adobe, which was named after the Adobe Creek that was behind Warnock’s home.

Laser printers and desktop publishing were just taking off. And shortly after founding, Steve Jobs tried to acquire the company for Apple. Eventually, Apple made an investment and used their postscript language for Apple’s laser printers. Their postscript eventually became the industry standard for printing and it was licensed to hundreds of third-party software companies and printer companies.

Adobe was profitable almost immediately after its founding. And from there, it launched software product after product. It made digital fonts.?Then Adobe Illustrator. Then Adobe Photoshop in 1989, which became its flagship product. Then Premier Pro in 1991 and Adobe Acrobat and Reader in 1993. And on and on.

Today, Adobe is a company that provides a full suite of +20 tools for creativity. These include graphic design software, web design programs, video editing / animation / visual effects programs and audio editing software. Their main creative tools are:

• Adobe Reader, Pro and Sign – for document publishing and sharing.
• Photoshop – for editing images, graphics and art.
• Premiere Pro – for video and film editing.
• InDesign – for designing and publishing layouts for print and digital.
• Illustrator – for creating art and illustrations.
• After Effects – for creating visual effects and motion graphics.
• Lightroom – for editing, organizing and sharing photos.
• Premiere Rush – for editing, organizing and sharing videos.
• Stock – a library of photos, graphics and videos.

However, Adobe is now expanding from creativity tools into what they call “experience products”. These are tools that let creative professionals take their created media and utilize it in a user experience. This includes distribution, monetization, social aspects and such.

I put all their software into two buckets:

• Creative tools and infrastructure
• Operating tools and infrastructure

Adobe Has Fantastic Financials

Look at the income statement and balance sheet of Adobe. What should jump out at you is:

• Revenue grew from $4.1B in 2014 to $9.03B in 2018.
• In 2018, 65% of revenue was from creative tools and 21% was from operating tools.
• In 2018, 57% of revenue was from the Americas, 28% from EMEA and 15% APAC.
• Gross profits have consistently been above 80%.
• That’s right. The gross profit is over 80%.
• This is a combination of a +90% gross profit for their subscription products and a 30% gross profit for the supporting services and other.
• Pre-tax operating profit is +30%.

This business is a cash machine, throwing off +$4B in operating cash flow (2018).

The balance sheet is also really pretty:

• Working capital is strongly negative (-$2B in 2018) as customers pre-pay for licenses and subscriptions of digital goods that cost nothing to reproduce and deliver.
• Tangible fixed assets are small at $1B.
• Debt was $4B (2018) which would normally make me uncomfortable. But Adobe has a subscription model and an embedded customer base. There is predictability in revenues. The deferred (i.e., pre-paid) revenue in 2018 was $2.9B.

And management is doing exactly what you would expect with such a cash machine in a specialized software field.

• They are spending big in research and development (17% of revenue in 2018).
• They are spending big in sales and marketing (29% of revenue in 2018).
• They have built out global distribution and support for their products. They have:
• Online sales and third-party online sales.
• A direct sales force and local field offices.
• An army of value-added resellers, system integrators, retailers, and independent software vendors selling and integrating their products.
• Lots of licensing to other tech companies and products.

This is the kind of economic picture you only see for intangible products like software and intellectual property.

Adobe Has Powerful Software Economics at Global Scale

All of Adobe’s products are all digital goods. Everything is made of bits and bytes. Which means they can capture the benefits of digital economics:. These include:

• Zero marginal production costs.
• Low distribution costs.
• Non-rival goods that can be simultaneously used.
• Global scalability at low cost.
• Versioning. Multiple versions of their products can be easily created at different price points.
• Bundling.
• Complements can be added.
• Lots of integration into other software and products.

That’s all good. But Adobe does it on a massive scale.

Adobe sells foundational tools for a digital age. They specialize in tools for creativity and for the creation of content, which is now part of virtually every experience, interaction and communication online. Adobe’s products are used by a huge population on a daily basis. From video editors and photographers to animators and marketing agencies. Try to think of a business, media company or individual that doesn’t use Adobe products.

In my talks on digital economics, I have argued they are fantastic but also dangerous. The same economics that can make software ridiculously profitable also tends to make it free and facing endless competition. Some apps are your smartphone are making money. But most are free.

If you are going to be in purely digital goods (like Adobe), you absolutely need a competitive advantage.

Adobe PDF Captured a Standardization and Interconnection Network Effect

In the 1980’s, there was lots of talk about file formats. Bill Gates used to talk a lot about the need to control the file formats for documents, media and other. Microsoft ended up owning the file formats for documents (.doc), spreadsheets (.xls), presentations (.ppt) and several others. It’s fun to dig into the patents for some of these and see where these standards came from. For example, the .jpeg format everyone uses for photo compression stands for the Joint Photographic Experts Group.

Adobe captured .pdf, which stands for “portable document format”. This is the file format that everyone uses to publish and share documents. It is the global standard. And it gave Adobe a durable competitive advantage, which was a?Standardization Network Effect.

As I’ve said many times, if lots of people go to KFC it doesn’t make your chicken taste any better. But if lots of people are using the pdf format for document publishing and sharing, it makes your Adobe Acrobat tool better. Standardization in file formats has lots of economic benefits:

• We can all share documents and interact with each other.
• We can all learn just one publishing tool. That decreases the training requirements.
• Other companies can create integrations and complements for just this one standard. Like add-on tools for adding signatures. They don’t have make and continually update complements for lots of document formats.
• Software developers can make their programs integrate and connect with the pdf format. They don’t have to make ten different versions for ten different document sharing formats.

It’s a standardization network effect. A common standard becomes dramatically more useful. And everyone saves time, effort and money.

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Adobe captured this network effect by being an?early mover?and?by using a?freemium model.

Adobe was an?early mover?in the desktop publishing space. Being early is critical for network effects based on creating a standard.

But Adobe also used a?freemium model.

• They give out Adobe Reader for free.?As I have said many times, once you go from charging consumers $1 to $0, your adoption really jumps. Free is not just another part of the elasticity curve. It is an entirely different world. Giving away a free version was critical for getting usage and building the network effect. And because it’s a digital good, giving away free versions didn’t cost Adobe anything.
• They also did pricing and versioning.?Adobe created multiple versions of Acrobat with different features for different groups (students, businesses, professionals). And at different price points. This encouraged adoption as it optimized the product and price customer segment by segment.

That is just great strategy. And it got them a network effect. Even today, Adobe says its biggest priority is to continually attract and retain users. This is about maintaining network effects for some of their products.

Adobe Crushes Competitors With Integrated Bundles

You can see how Adobe grew to a full suite of creative tools. And that was an interesting strategic choice. Microsoft did a similar expansion of software tools but focused on productivity at work. Microsoft Word was joined by Excel and PowerPoint and became Microsoft “Office”.

Another competitive strength of digital goods is the ability to bundle. For example:

• In the 1990’s, there were multiple competing products for Word, Excel and PowerPoint. Each product cost about $500.
• Microsoft bundled its three products into Microsoft Office and priced it at $1,000. This was devastating for its competitors.
• These single product companies could not compete with Microsoft’s three products at a 33% cheaper bundled price.
• Plus, most of these competitors had no ability to offer the other products. They all disappeared.
• And this didn’t really cost Microsoft anything. Digital products have no marginal production costs. So offering one product for free was lost revenue but it didn’t actually cost anything.

Adobe has done this same bundling move. You can buy 1, 2, 3 or more Adobe tools at different bundled prices. You can buy their full suite at a different price. They keep changing their bundles and prices to offer what their competitors cannot.

But they didn’t just bundle their tools. They integrated them. The functionality of many of their products improve the functionality of others. As a customer, the more products you buy, the better they tend to be. For example, you can buy Premier Pro to create videos. But if you also buy After Effects, you make those videos much better.

Bundles are a powerful competitive move. And integrated bundles are even better.

Adobe is currently adding operating tools to its creative tools. That should give Adobe the ability to create even more integrated bundles. You can now buy products that add advertising to your created media. You can create consumer experiences (websites, mobile apps). You can add social and sharing features to your created media. The integration of creative and operating tools and infrastructure is really interesting.

Note: You see this same approach at Epic Games. They provide creative tools for game designers (e.g., Unreal Engine) but also operating tools for monetizing, distribution, social features and advertising.

Recurring Revenue Bundles Are Called “Rundles”

Ok. The last concept for today is the “rundle”. I’m not sure this is really a concept. But it’s a funny word.

Over time, Adobe went from distributing disks to download its products. Both from the cloud and also from mobile apps stores and other locations. And it also went from licenses to monthly and yearly?subscriptions.

And that’s great. A subscription model gets you recurring revenue, which makes your financials look pretty. It also creates some small degree of switching costs. But when you?combine subscriptions with product bundles, you get recurring revenue bundles, which NYU Professor Scott Galloway has called the Rundle. That’s what I see when I look at Adobe’s financials, a global rundle.

So now the company focuses its sales and marketing on these rundles. They:

• Get users onboard with free versions.
• Upsell users to paid products.
• Continually cross-sell other products.
• Build in switching costs and make sure customers do renewals.

And they keep expanding and upgrading their suite of creative and increasingly operating tools. It’s just a great model if you can pull it off.

Final Point. Adobe’s Risks Going Forward.

Adobe does have challenges. And these are really just the nature of the digital world.

• They have to worry about new industry standards emerging. What if there is a new file format that is better than pdf?
• They have to worry about evolving distribution. Adobe went from disks to downloads. From PCs to mobile. From enterprise sales by a sales force to viral products within organizations (i.e., Slack).
• They have to worry about lateral moves by competitors. Microsoft and Google have photo editing and other creativity tools.
• Most importantly, they have to struggle against the free nature of digital goods with no marginal production costs. There are free versions of most of Adobe’s products available online. I used to pay $22 a month to Premier Pro to make videos and then I switched to DaVinci, which is free. Digital goods always have strong pricing pressure. Adobe has to continually build and strengthen their competitive advantages against this.

Cheers, jeff

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I write, speak and consult about digital strategy and transformation.

My book?Moats and Marathons?details how to measure competitive advantage in digital businesses.

I also host?Tech Strategy, a podcast and subscription newsletter on the strategies of the best digital companies in the US, China and Asia.