This Thursday I deliver the quarterly snapshot on the TSIA Service 50.
How are revenues, margins, and profits trending for the technology companies? Join me to find out.
Interesting trend in this snapshot: Product margins improved for IBM and Dell. I will drill into this and other ciritcal datapoints as we explore the performance of high tech business models.
My last blog entry was rather pessimistic. I promise I will lighten it up before the end of the first quarter. But not yet.
Comdex 2000:
LAS VEGAS, Nov. 13, 2000 The path forward for computing will involve software applications interacting with each other to gather rich information from many different sources and present a consolidated view to the user, Microsoft Chief Software Architect Bill Gates told a capacity crowd of more than 12,000 attendees last night as he kicked off the COMDEX/Fall 2000 Conference with a keynote speech at the MGM Grand Garden Arena.
John C. Dvorak, 11.20.00, 12:01 AM ET
LAS VEGAS – Comdex is the trade show you love to hate, and upward of 200,000 visitors love to hate it. Even Las Vegas loves to hate Comdex as cabbies, waiters and others complain that the computer show attendees are cheap. They don’t gamble and they don’t tip. On the other hand, Comdex is the show that made Las Vegas what it is today. Comdex forced Vegas to change its business model. Instead of rooms that had included free food and a bag of nickels for $40 per night, the hotel casinos can now charge $300 per night and always fill to capacity. Comdex is the show that drove this change in thinking. And that’s what this show does for the industry too. It drives a change in thinking.
Comdex 2012:
Have you been reading the reporters that are covering Comdex this year? Everyone in tech is familiar with the largest technology related conference on the planet. Every year, techies converge on Las Vegas to view the latest and greatest in tech gadgets. The conference has a legendary reputation. Yet, read the headlines streaming out from this year’s Comdex:
In fact, I have been hard pressed to find much positive news from the conference this year. The reporters are all banging in the same themes:
What do the experts believe is driving the slow demise of Comdex?
Perennial Market Flops: Last year’s releases were market flops, so buyers are cautious. It has become harder and harder to release a new product that generates real market buzz.
Changing product life cycles: When Comdex first incubated, technology companies were typically introducing their new products in Q1. These were the products the companies expected to ride through the remaining calendar year, into the holiday shopping season. Today, companies are being forced to refresh products every four months. Products released in January may not even be on the shelves come November.
Blurring Markets: There is no longer a crisp market titled “consumer electronics.” Are tablet computers for consumer or enterprise applications? Are gaming systems really gaming systems or multi-media consoles? One blogger from ZDNet wrote:
“Essentially, there’s too many vendors chasing an increasingly narrow customer base for a product category or group of product types that have become heavily commoditized and are victims of convergence.”
Why is Comdex relevant to Enterprise technology providers? Because the trends that are creating challenges for Comdex will be creating challenges for all technology providers—regardless of the market being served. It is becoming harder and harder to create a market changing product release that blows away the competition. Even if you do have a killer product release, the ability to ride that product has dwindled from quarters to months. And customer experiences in one market are influencing expectations in other markets. The user experience from an iPad or a Wii are influencing what customers expect from that clunky enterprise application you expect them to muddle through.
I am sure that twelve years ago, the folks in charge of Comdex were convinced the party would never end. Oh, what a party it was.
First entry of the New Year. Typically, these things are bouncy and optimistic. This time of year, everyone has that “clean desk” mentality. Anything is possible. Unfortunately, I am just not feeling it as the technology sector enters into 2012 In fact, I have a foreboding feeling inside.
The Potential of 2011
Way back in 2009 and 2010, when many sectors were reeling from the global downturn, the tech industry was navigating the stormy seas rather well. Yes, product revenues were down. But service revenues were holding and profits were actually increasing. By the beginning of 2011, product revenues were once again growing and it appeared the tech industry was poised for a wonderful year. But it never came to be.
he Realities of 2011
By the time we took the Q3 2011 snapshot of the TSIA Service 50, it was clear the tech industry was not enjoying the best of years. Every quarter, we compare service margins, product margins, and operating incomes from the same quarter the previous year. The graph below from the Q3 snapshot documents a very humdrum 2011 for the tech companies in the index.
More specifically, some of the market leaders demonstrated chinks in their financial armor:
Cisco
Cisco limped through 2011. Their own analysis in their most recent 10-Q is not very encouraging:
Gross Margin
In the first quarter of fiscal 2012, our gross margin percentage decreased by approximately 1.6 percentage points, as compared with the first quarter of fiscal 2011. Within this total gross margin change, product gross margin declined by 2.5 percentage points, while service gross margin increased by 1.5 percentage points. The decrease in our product gross margin percentage was a result of higher sales discounts and unfavorable product pricing, and product mix shifts. Partially offsetting these decreases in product gross margin were lower overall manufacturing costs, higher shipment volume, and lower amortization expense from purchased intangible assets. The increase in our service gross margin was due to increased volume, partially offset primarily by increased costs and to a lesser degree, unfavorable mix impacts.
In other words, Cisco is confirming a very troubling trend:
Product shipments are trending higher, manufacturing costs are trending lower, BUT product margins are trending lower due to increased discounting.
Oracle
Oracle ended 2011 with a financial groan, as documented in this Wall Street Journal article:
Piper Jaffray wrote that Oracle’s Q2 results illustrate a “clearly more sluggish spending environment.” They predicted “continued unexciting growth” over the next two quarters.
The Realities of 2012
The above data is all old news. Right? It’s the New Year! Yes, it is a new year, but I do not see tech shaking this funk anytime soon. In fact, I feel it will get tougher in 2012 for the legacy providers. Even if the global economy does not falter, the financial models for tech companies will struggle in 2012. Why? Because the three most important plays in the tech company playbook don’t score easy points anymore.
Old Play #1: Next Generation Product Release
When margins start to lag, tech companies look for that next hot product release that will reinvigorate pricing points and margins. The margins on new tech products are commoditizing at alarming speeds. Look at everything from the price of an Ethernet port to the price of a tablet computer for validation of this reality.
Old Play #2: Acquire Revenue and Margin
Legacy tech companies with lots of cash on hand love to run this play. Oracle, obviously, has been very proficient at this play as pointed out in the Wall Street article:
But Piper Jaffray saw a silver lining in Oracle’s ability to “acquire companies with 10%-20% operating margins, strip out costs, and rapidly realize 40% operating margins for the acquisition targets”
On Oct. 24 Oracle said it would purchase cloud customer service company RightNow Technologies for $1.5 billion.
“As such, we remain optimistic about Oracle’s aggressive acquisition strategy, which we describe as an ‘earnings arbitrage’.”
Here is the rub: the up and coming stars in tech are not printing cash. Let’s say SAP decided to purchase Taleo to counter the Oracle purchase of Right Now. In their most recent 10-Q, Taleo posted a loss. What if Oracle decided to gobble up salesforce.com? Salesforce, which has been around for over decade, continues to lose money. I am not convinced that Oracle could purchase salesforce, strip out costs, and have a new 40% margin engine. The SaaS model is simply not yet performing at that financial level.
Old Play #3: Cut Costs
Tech companies learned from the largess of the dot com era. Over the past decade, they have become masters of cost control. Which is why there is very little upside left in this play. Unless, of course, tech companies start requiring their employees to travel “cargo class” on business trips.
Adversity Creates Opportunity
Now that I have thoroughly depressed all of my tech industry peeps, let me offer a word of encouragement. Even though I believe 2012 will be a tough year for many tech companies, I also believe 2012 will be a year of business model innovations. I promise to carry this optimism forward in my next post by commenting on some of the wonderful bright spots I see in the industry.
It is that time of year again, when the TSIA research team huddles, discusses, debates, and then documents our research agenda for the upcoming year. This past year, TSIA published the book Consumption Economics: The New Rules of Tech. This book was written to clearly document how traditional technology markets are changing. The book identifies several key trends that are forcing companies to alter their service strategies. These are the same trends that are heavily influencing the agenda of the TSIA research team:
A majority of these shifts in market dynamics are not new from last year. However, they are requiring tech companies to revisit how they will we pursue target markets. How does a tech company go to market with cloud applications? What is the role of partners if customers now purchase subscriptions from product companies directly? And what does the business model for a product company look like when customers are not willing to spend significant amounts of upfront cash on licenses and maintenance contracts?
The TSIA research team has vetted these trends with the Advisory Boards for each service line TSIA supports. But I am very curious how you see these trends influencing your service business in 2012. Which one of these trends will have the GREATEST impact on your service business next year? Take a second and vote below. I’ll publish the results right after the holidays.
Once a year, I have the privilege to teach an MBA class titled “Building Service Organizations.” My goal is to introduce budding managers to the nuances of building and optimizing human capital intensive service organizations. In the first day of class, I flash this diagram:
The point is simple: we are living in a services economy. This means, as young managers, you need to learn how to build service businesses.
This is simply not right. At least the Fisher College at Ohio State University has been kind enough to indulge me in my outrage and allow me to teach this course once a year. The course culminates in a final exam which is short answer and essays. One of the essay questions I asked this year was as follows:
After studying the complexities of building service capabilities, what do you believe are the top three (3) challenges a company faces when they decide to create a service organization? Describe, in detail, each of these. Explain why these three challenges are the most significant.
Now, keep in mind that these are second year MBA students. This is the first exposure they have had to any content related to building a service business and the nuances of building a service business to complement a product business. Read some of the excerpts from their answers:
“The first major challenge is getting the charter for the services organization correct. This drives the structure and the decisions of the organization from the top down. If the charter is not understood, the financial results for the services organization may be off target with management expectations.”
“Generally speaking, Wall Street does not view services as a great offering compared to products. The threat of the stock dropping in value is enough to keep product companies from looking into services.”
“Companies can get into a thrashing cycle when trying to develop a service business because they lack the required patience. A company may feel they need services, but lack the patience to fully develop them, which causes them to constantly try, and fail, at building service capabilities.”
“When a product company decides to create a services organization, they can estimate the costs of delivering services. However, they won’t really have an idea of the financial model for the services business until they start delivering the services. Pricing, demand, and availability of human capital fluctuate from the original plan.”
“I believe that companies have trouble getting buy-in across the business for a shift in the mix of products and services. Top leadership will want to please shareholders, who are short-sighted about the business.”
“I think the top challenge is that product companies blend their support services revenues into total service revenues. This creates a misleading image of the true profitability of all service lines which can create the wrong expectations on service profitability.”
“Many companies are successful because they focus on their core competencies. They are strongly biased towards existing products. New service offerings may be seen as diverting focus on resource from a core function.”
These are insights and understandings based on taking one quarter of service related content. Can you imagine how prepared they would be for a services economy if they could major in this topic?
In previous blog posts, articles, and books, I have written extensively on the product to service mix of technology companies:
How Much Revenue from Services?
The bottom line: service revenues are critical to the economic health of product companies.
The Growing Annuity Revenue Stream
It is important to understand that the majority of the service revenues for product companies are annuity based revenues. In other words, the customer is signing an annual or multi-year agreement for services. These can be support services or managed services. For mature software companies, these annuity service revenues can easily represent 40% to 70% of total company revenues. Now, layer on the fact that some software and hardware revenues are migrating to subscription pricing models. These revenues are classified as service revenues and become another annuity revenue stream that must be managed. When the dust settles, product companies will find that the vast majority of their revenues will be represented by annuity based services. If this the direction revenues are heading, then product companies had better be VERY good at managing this type of revenue stream.
Service Revenue Generation
From the TSIA perspective, Service Revenue Generation (SRG) is the discipline of attaching, renewing, and up selling technology services. This discipline cuts across sales, marketing, and service delivery activities. To be excellent in this discipline is to be excellent at protecting and growing annuity based service revenues. The diagram below scopes the activities and revenue streams related to SRG:
Service Revenue Generation Dashboard
Now, how does a product company know if they are good at service revenue generation? This is the very question we asked Julia Stegman. Julia is a sales executive with extensive experience in protecting and growing annuity based service revenues. She has recently joined the TSIA team to lead our research efforts in the area of Service Revenue Generation.
Julia argues that product companies must excel at three key motions if they hope to protect and grow annuity service revenues:
Below is a draft of the dashboard view of these three motions.
What specific practices should product companies have in place to move the needles on this dashboard? What metrics should companies be tracking related to these three motions? Julia has been working with an advisory board of industry executives to finalize the answers to these very questions. For more information on this new TSIA initiative, I recommend you contact Julia directly at julia.stegman@tsia.com. You can also follow her blog “Up and to the Right.”
All I can say, is that there is a lot of money on the table here. Annuity service revenue streams: that is where the growth game will be played for so many product companies.
I just returned from a business trip to Europe. As I reviewed the global service business of this TSIA member I was visiting, I came to the realization of a brutal reality facing so many of our TSIA members:
The Commoditization of Complexity
What do I mean? Let me explain
Definition of a Commodity
A commodity is some good for which there is demand, but which is supplied without qualitative differentiation across a market. In other words, customers can’t really tell the difference from one offering to another—they are interchangeable.
Traditionally the term commodity was applied to the following types of categories: (Coote, 2000)
These categories fit our concept of a commodity because, regardless of where you buy these items, they are the same product. Regardless of where I buy a piece of corn, I am still buying this known product called “corn.” We can debate if corn grown in one location is way better than corn grown in another location, but you get the general idea.
In a commodity market, many companies compete and none enjoys a competitive advantage. This reality typically leads to smaller and smaller profit margins for companies that provide the offering. Also, the importance of any factor other than price (such as brand name) diminishes.
Complex Offerings
Complex offerings, by definition, “consist of interconnected or interwoven parts.” This is the opposite of a commodity—where we are typically referring to items like corn, or silver. A PC is a complex offering because it involves the integration of a host of hardware and software technology in a rather tight physical footprint.
In the past, technology companies have emphasized complexity to justify premium pricing. “Hey, if everyone could get this complex solution to work, it wouldn’t cost so much. But this technology is complex.”
The Commoditization of Complexity
In today’s technology market, I am seeing the commoditization of complexity. There are companies that deliver very complex technology solutions to the marketplace but are now being treated by the marketplace as a commodity. Beyond the poor PC manufacturers, there are a host of examples:
You can see the commoditization of these solutions reflected in the downward trends on product margins. These are incredible, innovative, complex technologies—but customers are treating them like a commodity. To put an exclamation point on this trend, check out this headline that appeared in CNET this past summer:
Analyst: Expect tablet market to commoditize
Didn’t Apple just create this market?
The Rule of Three
Customers are smart. As they drive vendors to commodity pricing, they will make sure that at least three vendors stay viable in the marketplace. This guarantees ugly price wars as each vendor vies to buy the business. No vendor will be allowed to dominate. More than one vendor will be kept alive to prevent monopoly pricing. Great book by the same title: The Rule of Three
The Path Forward
The commoditization of complexity is already creating all kinds of consternation for technology companies. How will tech companies navigate this ugly twist in the road? I predict technology companies will land on one of three economic engines:
The commoditization of complexity is painful. If you are a tech company, your business model will need to land on one of the above three squares. But please keep in mind that the “differentiated engine” square is rapidly shrinking, and the “consumption engine” square is rapidly growing. You might want to consider playing the probabilities on this one.
This Thursday I deliver the quarterly snapshot on the TSIA Service 50.
How are revenues, margins, and profits trending for the technology companies? Join me to find out.
In addition, I will be applying insights from this public data to the new frameworks we have published in Consumption Economics. How fast is the tech industry entering the world of consumption economics? Let’s see what the public data reveals.
The last day of TSW! And still, we are cramming in great presentations.
Yesterday we saw a killer presentation by Guy Gauvin of Taleo. Guy showed how Taleo is already living and succeeding by the new rules of tech.
Today, Maria Martinez, the executive in charge of the “Customer’s for Life” organization within salesforce.com will be sharing the mission and tactics of her organization. Clearly, salesforce is already living and dying by the rules of Consumption Economics.
After the keynote, we have multiple breakouts scheduled. I will be hosting one that overviews our brand new PS ODP offering. TSIA members now have the ability to engage TSIA to audit and diagnose the maturity of over 200 processes related to executing a PS business. We launched the pilot for this program at the beginning of this year. The PS organizations from five TSIA members have participated, including , HP Software Services, Schlumberger, Ericsson, Microsoft, and EMC.
In my breakout today, I will overview how the PS ODP works and discuss some of the processes we evaluate during audits. For any PS organization looking for a mechanism to improve performance or align global processes, I recommend you stop in for the overview.
Thanks to the TSIA team and the TSIA members for another outstanding industry conference.
And have fun launching those trojan horses…
Yesterday, I spoke of the need for service organizations to drive tactics that will allow their companies to sustain current margin profiles. You can see the presentation by visiting: http://www.technologyservicesworld.com/consumption-economics.html
Today, I deliver a breakout session on a tactic that has helped high tech companies extend their current business models: serving emerging markets.
Since Las Vegas last year, TSIA has been telling member companies that “exciting” growth for technology products will not be coming from North America or Western European markets but new major markets such as Brazil, China and India. These markets represent wonderful growth opportunities for product sales. That is the good news. The bad news: How do service organizations successful sell and deliver their services in these new major markets?
Over the past six months, TSIA has been interviewing service leaders to discuss the specific challenges of selling and delivering services in Brazil, China, and India. These interviews resulted in a framework we call “Country Service Profiles.” A graph from that framework is below.
Today, I will present this framework in my breakout session and we will spend time discussing the specific challenges of selling and delivering services in China. Again, service organizations must be at the top of their game to defend their margin dollars. Accelerating success in tough service markets like China is yet another way to defend those service margins.
