During five days in August 2011, Adobe Systems Inc. (ADBE:US)’s top executives sequestered themselves in an 18th-floor boardroom atop the software maker’s Silicon Valley headquarters to address an emerging threat: the cloud.
Customers in growing numbers were opting for upstart competitors’ software, delivered instantly over the Internet and slowing purchases of Adobe’s programs. That jeopardized Adobe’s leadership in desktop publishing with products such as Photoshop, Illustrator and InDesign.
What followed was a wrenching decision by Adobe to eventually dump its lucrative licensing business in favor of a monthly subscription offering called Creative Cloud. The same shift is underway across the technology industry, as vendors including Microsoft Corp. (MSFT:US), Oracle Corp. (ORCL:US) and SAP AG (SAP) vie for a bigger slice of the $36.8 billion cloud software market, which will balloon to $67.3 billion by 2016, according to IDC.
“It was probably one of the most important moments in the company’s history,” said David Wadhwani, an Adobe senior vice president who attended the meetings. “I don’t think this was one where we were going to increment our way to the right solution.”
While the choice was met with angst among managers and engineers, the stock has almost doubled in the past two years. Even so, Adobe and fellow vendors are still playing catch-up to younger companies such as Workday Inc. (WDAY:US) and Salesforce.com Inc. (CRM:US) For Adobe, analysts project (ADBE:US) an 8.2 percent drop in sales and 65 percent plunge in net income this year, according to data compiled by Bloomberg.
All the incumbents face the same challenge. The $350 billion software market is stagnating, with annual growth of 6.3 percent projected until 2017, compared with 24 percent in cloud software through 2016, according to IDC. Gone are the days of being glued to a single machine -- software must be available on any device at any time.
Moving to the cloud means forgoing upfront contracts with lofty profit margins in favor of software-as-a-service (SaaS) products that pay off monthly and can be canceled if customers aren’t satisfied. The transition results in short-term revenue drops, often irking investors and leaving employees unsettled.
“The software world is heading down this path and there is no turning back,” said Brent Thill, an analyst at UBS AG in San Francisco. “It’s changing everything about the business model.”
That’s why Adobe co-founders John Warnock and Charles Geschke, who are also co-chairmen, urgently came together with Chief Executive Officer Shantanu Narayen and his top deputies two summers ago in San Jose, California, shortly after the five-day session. Executives followed up with a retreat just south in Carmel Valley.
The decision to go all-in on cloud wasn’t reached easily, said a person with knowledge of the meetings who asked not to be identified because the discussions were private. A faction of executives had to be won over, the person said.
Among salespeople and developers, there was angst about jobs, said Wadhwani.
Selling the changes to the company and analysts meant “a little less time at home, a little more time on the road,” he said. “We all needed to step it up.”
In November 2011, the company unveiled plans to eliminate 750 jobs as it shifted all its design-tool development to Creative Cloud. The new offering would charge users a monthly subscription of $50 rather than as much as $2,600 to own the full suite.
That model was pioneered by Salesforce and adopted by suppliers including Workday, NetSuite Inc. (N:US) and hundreds of startups. The six largest cloud-computing business software companies are on track to rack up $9.65 billion in sales this year, according to data compiled by Bloomberg.
“The market’s moved, but there are still a lot of folks out there who have anxiety,” said Jeff Teper, an executive in Microsoft’s Office group, which is bringing the company’s flagship software online.
Microsoft is forecasting sales of $1.5 billion over the next year for Office 365, a Web-delivered package of Word, Excel, PowerPoint, and other products that costs $100 per year for consumers. Microsoft is foregoing $150 million in sales of Office to consumers in the first quarter because of the transition, and revenue won’t increase again until 2017, Chief Financial Officer Amy Hood told analysts in September.
As it moves to cloud, Microsoft goes from being dominant to wielding less control. It’s chasing Google Inc. (GOOG:US), emerging companies like Box Inc. and increasingly Amazon.com Inc., which last month released WorkSpaces, giving workers a virtual desktop across devices, complete with Microsoft Office, Adobe Reader and Mozilla’s Firefox browser.
SAP and Oracle have each spent billions of dollars acquiring online-software companies in recent years as growth slowed. Oracle’s revenue over the past year increased 1.2 percent, compared with a five-year average (ORCL:US) of 11 percent. SAP’s rose 6.6 percent in the past year, compared with an 8.4 percent five-year average.
In addition to Salesforce, whose Web-based sales tools have been around for a decade, the older companies are losing business to Workday for human-resources software, NetSuite in enterprise-resource planning and Cloudera Inc. in data analysis software.
Those products, which were designed for the cloud, are often cheaper, easier to install and more suited for mobile computing. Updates are pushed out on a daily or weekly basis rather than just every few years when new products are released.
“SAP and Oracle know they’re going to have to deliver more and more of their functions as a service,” said David Yoffie, a professor at Harvard Business School and Intel Corp. director. “Much of their software isn’t engineered to work that way.”
In SaaS businesses costs are high for data centers and product development while the value of the contracts is recognized over time. Salesforce and Workday spend over 80 percent of their revenue on operating expenses and both are unprofitable. Oracle and Microsoft spend less than half.
“SaaS companies are much more capital intensive and that’s the disadvantage for investors,” said Rob Tarkoff, CEO of Lithium Technologies Inc., whose social-media monitoring software is used by Best Buy Co. and AT&T Inc. “Capital expenditures come way ahead of revenue.”
Startups have turned to venture capitalists for help. Lithium has reeled in more than $140 million. Box, a provider of collaboration software, has raised more than $280 million, and HootSuite Media Inc., which helps companies manage social-networking activity, raised $165 million in August.
The incumbents are using their balance sheets. Oracle, with $39 billion in cash and marketable securities, has acquired (ORCL:US) customer management, marketing and HR applications, including RightNow Technologies Inc., Eloqua Inc. and Taleo Corp., and is working to enable use of its main database applications over the Web.
SAP, the biggest maker of business-management software, spent $3.3 billion on SuccessFactors Inc. last year. The company is starting to offer its Hana database and analysis software as a service and working to get customers to rent software rather than buy it, said Vishal Sikka, head of software development.
UBS AG estimates that in the next decade, over half of software globally will be delivered as a service, up from less than 10 percent today. Thill, UBS’s software analyst, said he recommends (ADBE:US) investors buy shares of companies making the boldest moves.
“Adobe and Microsoft have been two favorite old-school names who we thought could make the transition faster,” said Thill. “The name I’ve been wrong on is Oracle. We thought they could make the transition faster.” He has buy ratings on all three.
Deborah Hellinger, a spokeswoman for Oracle, declined to comment, and pointed to the company’s Nov. 12 announcement that it would open four new data centers in Canada and Germany to serve up online software, bringing the total to 17.
Investors will see how well Adobe is progressing on Dec. 12, when the company reports earnings (ADBE:US) for the fiscal fourth quarter. After last quarter’s results, the stock rallied 9.2 percent, as investors rewarded Adobe for focusing on subscriptions even though profit sank.
“They basically threw in the towel,” said Thill. “They damaged the financials by hurting short-term performance for long-term gains.”
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