The following article was published in the WSJ today. I think it captures perfectly the issues we’ve been discussing on this blog.
Tech Giants Ramp Up Their Online Offerings
(From THE WALL STREET JOURNAL)
By Ben Worthen and Justin Scheck
The recession is forcing technology heavyweights Oracle Corp., Hewlett-Packard Co., and SAP AG deeper into a low-profit business that the companies have traditionally resisted: selling online software. As businesses look to cut costs many are turning to Web-based software, which saves companies from having to buy or maintain expensive back-office computers.
Instead, the software is run on servers owned by software makers and can be accessed over the Internet, making the total cost of the systems a quarter the cost of traditional software in some cases, analysts say.
Technology giants such as Oracle have avoided providing online software because it is less profitable than traditional software, and sales could cannibalize those of existing products. It also requires software vendors to absorb expenses, including hardware purchases, that previously have been borne by customers.
As recently as September, Oracle Chief Executive Larry Ellison declared that online software companies “haven’t figured out how to make money.” But now the Redwood Shores, Calif., company is developing more than 10 online software programs, including ones that track employees and job applicants, say people briefed on the matter. Oracle declined to comment.
Meanwhile, Germany’s SAP says it expects to release an online purchasing tool later this year, plus two other applications next year. H-P said earlier this month it will develop online versions of almost all its business software. And Microsoft Corp. and International Business Machines Corp. have also moved into online software over the past year.
The changes are being driven by customers, who are looking for ways to cut technology spending in the downturn. “There’s a lower total cost of ownership” with online software, says Joanne Cummins, chief information officer at printing company Standard Register Co. in Dayton, Ohio.
Ms. Cummins intends to replace Oracle software later this year with an online product. She says she doesn’t want to buy and manage the hardware needed to support traditional software, and wants to avoid having to upgrade to a new version of the software every few years.
Fully embracing online software is risky for big technology vendors. “My bet is that these large incumbents are going to be unable to cross this bridge,” says Bruce Cleveland, a venture capitalist at InterWest Partners who previously ran the online software business for Siebel Systems. “They will not be able to transform their business models.”
Most traditional software makers are used to immediately booking revenue from sales of their products. For instance, Oracle’s list price for its traditional customer-management software is $3,750 for every person in a company that uses it, plus $825 per user a year in annual support fees, though most companies receive a discount.
With online software, revenue is recognized over the length of a contract, which often run several years. One of the few online software products Oracle currently sells costs just $70 per user per month. The contracts are often unprofitable initially because of the upfront costs of setting up a new customer, but can be profitable if a customer stays on a system for many years.
The big software makers are just getting their feet wet in online software, analysts say. But the more online software these large companies sell the more likely they are to hurt their profit margins. Oracle currently has a net profit margin of 24.6%. In contrast, online software company Salesforce.com Inc. has a net margin of just 4.4%, though it spends a higher percentage of revenue on sales and marketing.
Switching from a traditional software business to an online model can be “hugely disruptive,” says H-P software chief Tom Hogan. “Shareholders don’t like it, and it’s a real conflict between business strategy and fiduciary duty.”
Some smaller companies that have already switched to selling online software have found the change difficult. Procurement-software maker Ariba Inc. posted several unprofitable quarters when it shifted in 2005 and saw its shares tumble. It’s “a tight rope to walk,” says Kevin Costello, Ariba’s president.
Overall, online software is estimated to account for just $9.5 billion of the $284 billion businesses will spend on software this year, according to research company IDC. But online-software sales are rising more than 40% a year compared with 3.4% for software overall.
Some big tech firms have tried to move into online software before – with difficulty. In 2007, SAP launched an online version of its management software with much fanfare. But to protect sales of its traditional software, SAP said it would only sell the online product to small- and midsize businesses that couldn’t afford its other software. Last year, SAP cut funding for the online software as executives said they couldn’t make any money on it.
SAP now plans to sell online software that complements its traditional software and doesn’t compete with it, and will have a separate telesales organization to push the new products, says John Wookey, an SAP executive vice president.
Interesting challenge for the larger traditional vendors. Brings back memories of when CA changed only its business model (and not its delivery model) to a term/subscription model and suffered for many years (ok and the legal issues were pretty bad as well). http://bit.ly/tK2CZ
Also requires changes to the development model relative to much more frequent “releases” than w/ perpetual software. Agree with Larry that it will be a long time before many SaaS companies support the kind of 50% operating margins that he enjoys, but maybe that’s a result of customers perception of value.
Hey Bruce- I agree with you that many of the big incumbents will not cross the bridge. What amazes me is how the main stream press focuses on the elephants, while the ants go marching by. Of course the huge players are going to be slow to adopt a technology that obsoletes their huge installed bases. The real story are the SaaS providers who are driving that 40% growth per year…they will be the elephants in the future.
More on the benefits of SaaS on my blog:
http://www.compensationmanagement.com/
Chris Cabrera
CEO
Xactly
Very nice read Bruce. Saas is certainly emerging. It’s not new though, some companies I know have been making money using this biz model many years ago. I think the big boys will catch up soon.