According to technology analysts AMR Research, more than 80% of customer relationship management (CRM) software deployments either don't add value, encounter user resistance, or fail outright. Such disappointment has made CRM customers vengeful and ready to support the growth of the software-as-a-service (SaaS) market, which includes customer-relationship specialists such as Salesforce.com (NYSE: CRM) and RightNow Technologies (Nasdaq: RNOW).
With SaaS, software is transforming from a product to an on-demand service, whereby software is delivered over the Internet in return for a fixed fee. Unlike the traditional software license model, there are either no up-front fees or very low ones.
Soothed by the business case
The business case for SaaS customers is soothing -- it's especially compelling for small and mid-sized businesses, which lack the infrastructure and large user populations of their bigger brethren. But the case is equally convincing for all company sizes.
- It saves a lot of money. A Yankee Group study found the total cost of operating an on-demand software package is less than half that for an equivalent system bought the traditional way.
- It's quick. With SaaS, software can be deployed in days and weeks, rather than six to 18 months with traditional license-and-install software.
- It allows IT departments to offload the delivery and maintenance of software applications. The SaaS firm, not the customer, invests in the technology, hardware, and ongoing support services.
- It lowers risk. Small and mid-size companies live in fear of the failure rates of large-scale enterprise resource planning (ERP) and CRM implementations.
- It's sound economics. In the traditional model, the supply and demand for features usually don't match. Companies buy software loaded with bells and whistles they don't need. In a 2005 IDC survey of 250 IT execs, companies said they use just 16% of the software they buy.
- It produces healthier relationships. The SaaS provider earns its return over the term of the relationship, rather than front-loading with a license sale.
So SaaS is great for customers. What does it mean for investors in the business software, services, and hardware sectors?
The SaaS model and investment opportunity SaaS changes the way a software company designs its products and how it delivers them, but most of all, it changes its economics. A quick tour of a typical SaaS income statement is instructive. At the top, revenue is initially smaller, but it's also much more stable and predictable, because customers make regular subscription payments instead of large up-front license fees and professional service fees. And these payments are annuity-like, since they are locked into two- to four-year contracts. The cost of revenues should also improve, since there is less investment in professional services because of rapid deployment and Web-based delivery. A fully developed SaaS company should produce gross margins comparable to those of the traditional software licensing model, but without the margin drag of professional services. Operating expenses also drop, because an SaaS company can support many customers on a single, shared application and infrastructure.
The investor opportunity in SaaS remains attractive and will continue to develop in 2007. There are at least three key themes to think about. First, Salesforce.com has matured into the dominant pure-play SaaS provider, and its AppExchange platform moves the company well beyond CRM applications. In addition, the company is successfully reaching the large-company market, with clients including Cisco, ADP, and Merrill Lynch.
Second, as SaaS spreads to non-CRM functions, it creates new investment opportunities. Webex Communications (Nasdaq: WEBX) helps road warriors stay at home by offering Web conferencing and collaboration tools. Valuation of Webex remains calm compared to Salesforce -- it trades at a price-to-sales ratio of 4.5 and an enterprise value-to-EBITDA ratio of 12, as opposed to Salesforce's respective ratios of 10 and 94. According to SaaS expert Michael Mankowski at Tier I Research, the human capital management (HCM) application should be hot in 2007, and publicly quoted companies in this space include Kronos, Kenexa, and Taleo.
The final theme to consider is that of acquisitions and consolidation. In 2006, Intuit (Nasdaq: INTU) acquiredDigital Insight (Nasdaq: DGIN), and such transactions will likely continue.
SaaS affects hardware and IT services, too
SaaS is expected to grow to capture more than 25% of the $200 billion business software market by 2011, according to technology analysts Gartner. SaaS also accelerates some visible industry trends.
The first trend is that large enterprise software companies are treated as value, not growth, investments. After a rugged, high-growth youth, large software companies are mellowing into value stocks. They earn stable recurring maintenance revenues (40% of total revenue is typical) from large installed customer bases and have growing piles of cash. Understandably, to protect this business, they are taking a measured approach to expanding their SaaS offerings. Also, software companies tend to be lightly leveraged, which, coupled with the steady maintenance revenues, makes them targets for the merchants of debt. Witness the purchase of SunGard Data Systems by a consortium of private equity firms for $11.3 billion.
Second, SaaS may contribute to harder times for hardware sellers who don't shift themselves to an on-demand model. Companies do not need a lot of gear with SaaS: A Web browser and a broadband connection is the entire IT infrastructure needed. On the other hand, of course, SaaS companies do need others to manage their infrastructure -- data centers, servers, storage, and middleware -- and they need service delivery platforms.
Third, the traditional model of selling enterprise software -- IT-service firms that serve as a sales channel, in return for a consulting engagement to implement the software -- may suffer. Companies such as IBM (NYSE: IBM) and Accenture (NYSE: ACN) are responding by stressing industry expertise and cutting integrator partnerships with the larger SaaS players, such as Salesforce.com.
SaaS expands across functions and businesses
The base case for investing in SaaS companies is the ability to access a new growth opportunity -- the 50 million small- and mid-sized companies in the world that cannot afford or fear the risk of enterprise-class software. As SaaS matures, the opportunity to extend to large companies and across functions beyond customer relationship management creates the most important software growth opportunity for 2007.
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This article was originally published on June 6, 2006. It has been updated.
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Fool contributor John Finneran writes and advises on increasing the financial value of technology. He is currently ranked 26 out of 19,225 participants in Motley Fool CAPS and does not own a position in any of the companies mentioned. The Fool has a disclosure policy.
#1 Change is Imperative
That quote epitomises Microsoft's problem: An unfocused, strategic timidity that follows rather than drives trends.
Web-based productivity is not in the 'early days'. It is already a reality, as Netsuite, Google Apps, RightNow or Salesforce would attest. Once again, Microsoft will enter the market five years behind rivals, and somehow believe throwing money at the problem will result in market leadership.
Microsoft's dangerous dependence on Windows (62% of operating profits) and Office (50%) is the result of a history of missed opportunities to
diversify:
1) Microsoft missed the boat on creative software and allowed Adobe and Corel to dominate the market with overpriced, bulky products like Photoshop, Illustrator, Pagemaker and later Flash and Dreamweaver. Adobe's 2006 revenues were $2.6bn. A decade or more later, Microsoft now belatedly launches Expressions.
2) Microsoft missed the boat on ERP software, allowing SAP, Intuit, Oracle, etc to dominate this billion dollar market. SAP's operating profits are 16% of Microsoft's. After failed merger initiatives with SAP and Intuit, Microsoft belatedly now offers Dynamics.
3) Microsoft missed the boat on gaming. It seemed to do well as the (belated) Xbox siezed market share, but the blue ribbon for innovation goes to Nintendo and the Wii. The Xbox loses money ($1.26bn loss in 2006 or 8% of operating profits), because instead on focusing on games as software and online services, Microsoft bumbled into low-margin consumer electronics. If a division that loses $1.6bn is considered a success, the bar is very low indeed.
4) In the 1980s and 1990s, Microsoft missed the boat on the burgeoning market for IT consulting services, preferring to rest on Windows laurels and instead actually certify individuals and partners to support Microsoft networks and thereby cash in on the massive demand for technical services. Today, IBM's profits are 73% and Accenture's 11% of Microsoft's.
5) Obviously, as Mr Ozzie laments, Microsoft missed the boat on web advertising. Google's service is atrocious: rates paid to publishers are criminally low compared to offline rates, all ads look the same, there's no option to customise ads or choose where they will be placed, and the 'smart'software often places irrelevant ads on websites. They are ripe for leapfrogging by innovative competitors. Alas, the smaller companies innovating in this space- like Chikita- lack the resources of Microsoft.
In addition to missing out on these billion dollar nascent markets, Microsoft launched a series of strategically misaligned ventures. Speaking of low margin electronics, the Zune is an ill-advised, doomed project driven by Apple envy. Consumer electronics industry margins are paltry compared to software. Mere pennies are made from songs or movies sold. What is Microsoft doing in this business? In strategic desperation, the product is now being virtually given away. The superfluous Microsoft Network lost $77m in 2006.
Also, spoiled by decades of being able to dictate to customers (and thus being outflanked by Linux and Apache), Microsoft launched the ludicrous Home Media Center. Presumably, people don't suffer enough frustration maintaining servers in the office: they need to do so at home as well. The future multimedia home WILL be networked- but to the internet, not to a home server.
The real reason Microsoft is hesitant to embrace software over the web is strategic inertia and dependence on the Windows/Office cash cow. One wonders what Microsoft spent $20bn on R&D on over the last 3 years, when profits are still being earned by 20 year-old products, and all Microsoft's new products are copycat me-too entries. However, the SaaS revolution offers Microsoft's last great chance to rectify previous oversights and dominate a new industry. To do this, I would humbly recommend the following to Mr Ozzie:
1) Accept that Windows is doomed. Computing will shift to the web. Storage, service and maintenance will always be cheaper and more convenient on a network than on a single owned device. Broadband will obliterate PC-based software.
2) Redefine Microsoft as a software services company. Sell off anything unrelated to this definition. Start with the Zune. It was a tragic mistake. Sell off the Microsoft Network. Microsoft is not a media company, and never will be. Yahoo lags Google precisely because despite earning most of its profits from advertising, it distracts itself with content management. Eyeballs are not dollars. Offer a complete suite of web-based software via single logins to individual and business accounts. This means Office, web-based ERP, web-based Outlook, Expressions, etc by online subscription. Now. Login boxes should be via the Microsoft homepage to pull together the new vision of a software services company.
3) Regain the ERP market by building the first 100% web-based ERP solution for large enterprises using AJAX. In the absence of a merger with SAP, this is the only way to own the ERP market of the future. Salesforce and Netsuite did it. While SAP and Oracle dawdle, this is your chance to sieze the ERP SaaS up market. When slow-moving Fortune 500 enterprises finally decide to switch to SaaS,have the product ready for them.
4) Regain the creative software market by raising the profile of the Expressions suite and offering it over the web, at a large discount to Adobe's overpriced offerings. This is the only chance of gaining share from Adobe.
5) Defeat Google in web advertising by first putting the Windows Live search box on the Microsoft homepage (the world's 2nd most visited website, see point 2). You might find then that you won't actually have to bribe companies to use your search engine. Offer web publishers higher CPMs than Google, and publish these rates. Enable ads to be easily customised.
6) Change the gaming strategy. Sell the loss-making Xbox, merge with Electronic Arts ($2.9bn 2006 revenue), and reposition as the world's premier game developer and online gaming service via X-box live. The gaming division might actually turn a profit that way. Make Sony, Nintendo and the Xbox buyer your customers, not competitors (and who knows, Media Center might then follow their devices into the living room). Consumer electronics is no place for a software company. Xbox is not the route into the living room.
The future of Windows (if it is lucky) is on mobile phones and in living room devices connected directly to the internet. It's not a bright future, as its primary purpose will be to launch the browser so users can access web applications, on-demand movies, music and user-generated content over the internet in their living rooms. The future, however, is extremely bright for Internet Explorer, if it is radically enhanced for web-based multimedia and made ubiquitous on mobile and living room devices. Please talk- very humbly- to Nokia and Sony.
The shift to web-based computing is a seismic revolution that Microsoft could dominate - if it could only, for once, shrug off big company risk-aversion and sieze the day first, as it did many glorious years ago.
Sent: 12:03 PM Thu Apr.05.2007 - BN