Adobe (ADBE -0.77%) transformed all of its desktop software into cloud-based services over the past decade. That bold evolution, which started with the launch of the Creative Cloud on April 12, 2012, initially squeezed Adobe's margins, but ultimately boosted its revenue by locking its customers into sticky cloud-based subscriptions.
If you had invested $2,000 in Adobe on Creative Cloud's launch date, your investment would have grown to $23,000. That same investment in an S&P 500 index fund would only have grown to about $7,400 after including reinvested dividends. Let's see how Adobe transformed its business, why it outperformed the market, and where it might head over the next decade.
Image source: Getty Images.
Why did Adobe evolve into a cloud software provider?
Between fiscal 2001 and fiscal 2011 (which ended on Dec. 2, 2011), Adobe's annual revenue grew at a compound annual growth rate (CAGR) of 13% as its net income increased at a CAGR of 15%. However, its annual gross margin declined from 93.4% to 89.6% as its annual operating margin shrank from 30.8% to 26.1%.
That compression was attributed to its lengthening upgrade cycles and its loss of pricing power. Back then, Adobe's customers bought a new version of its desktop software every few years and stuck with it until it became outdated. That business model worked when each new version marked a major upgrade, but it lost its potency when those upgrades became less essential. As a result, its customers stuck with their outdated software for longer periods and eroded Adobe's pricing power.
Realizing that secular shift would disrupt Adobe's long-term growth, CEO Shantanu Narayen made the tough call to replace all of its individual desktop software licenses with cloud-based subscriptions. That shift started with the launches of its Creative and Marketing Clouds in 2012, followed by the introduction of its Document Cloud in 2015. It subsequently bundled its advertising and analytics services into the Marketing Cloud to launch its Experience Cloud in 2017.
The following year, Adobe expanded the Experience Cloud's e-commerce capabilities by acquiring Magento. That segment, now known as Adobe Commerce, competes against Shopify in the e-commerce services market. And just last year Adobe agreed to buy Figma, a leader in user interface (UI) and user experience (UX) design, to take out a major competitor for its own Adobe XD platform while expanding its Creative Cloud ecosystem.
How fast has Adobe been growing?
Narayen's plan initially alienated Adobe's longtime customers, throttled its revenue growth (since monthly subscriptions generated less upfront revenue than single licenses), and compressed its margins as it expanded its cloud infrastructure.
But it was ultimately the right move. Between fiscal 2011 and fiscal 2022, Adobe's annual revenue rose at a CAGR of 14% as its net income increased at a CAGR of 17%. Its annual gross margin dipped to 87.7%, but its annual operating margin rose to 34.6% after it scaled up its cloud infrastructure and economies of scale kicked in.
If Adobe had continued to only peddle desktop-based licenses while shunning cloud-based services, its growth would likely have slowed to a crawl as customers stopped upgrading their software. But today, Adobe's long-term prospects still look bright because its cloud subscriptions are sticky and its core Creative Cloud products -- Photoshop, Illustrator, and Premiere Pro -- remain industry-standard tools for media and design professionals.
That successful transformation into a cloud software giant bears a strong resemblance to Microsoft's transformation under CEO Satya Nadella over the past nine years. Just like Adobe, Microsoft transformed its desktop software into subscription-based cloud services to lock in its customers and stabilize its long-term sales growth.
Will Adobe continue to grow over the next decade?
Adobe has faced some tough macro and currency headwinds over the past year, but its core business will likely continue to expand over the next 10 years. It might not replicate its multibagger gains from the past decade, but it has an evergreen business model and a wide moat, and its stock is still reasonably valued at 25 times forward earnings.
