Double Click on the SaaS Business Model

Current Wisdom

Yesterday, my colleague Maria Manning Chapman forwarded me an article from Tien Tzuo, a former marketing executive at salesforce.com:

Wall Street Loves Workday, but Doesn’t Understand Subscription Businesses

I strongly agree with his title but vehemently disagree with the content in his article. Mr. Tzuo makes a compelling argument for why it is justified for SaaS based companies such as Workday to receive such outrageous valuations.  The crux of his argument rests on the importance of “deferred’ or “unearned” revenues. Currently, salesforce.com is sitting on top of over three billion dollars in deferred revenues. In their last annual report, Workday stated they have almost $300M in unearned revenues. To date, investors are clearly bought into the importance of these deferred revenues. The table below stacks Workday next to Oracle. As can be seen, Oracle out strips Workday in all key financial metrics except one: deferred revenues. Clearly Mr. Tzuo is on to something.

 

Fly in the Ointment

As Mr. Tzuo correctly points out, stock price of any company is a function of FUTURE potential, not past results. When a company has so much deferred revenue already on the books, the future looks very bright indeed. But, what if in the future, a company does not make any profit with these currently deferred revenues?  What in the future all of that deferred revenue and additional booked revenue barely pays the bills for running the company? Would investors still be so excited about the future of the company?

Theory of SaaS Profitability

SaaS companies are running to a pretty straight forward business model. They build platforms. As more customers get on those platforms, revenues will eventually outpace expenses and the business will generate profits. The image below documents the theory. All SaaS companies are navigating how to maximize upfront investment costs to propel them over to profitability.

The Realities of SaaS Profitability

The challenge with the theory of SaaS profitability is that is has been under accounting four critical factors:

1. The increasing costs to support and serve customers
2. The increasing costs of acquiring new customers
3. The downward pressure on subscription pricing (as markets become competitive)
4. The percentage of deferred revenue that becomes bad debt

Each one of these factors deserves a TSIA research paper in itself, so I will not elaborate further on them in this blog entry. I will only state that these factors are proving significant and they are resulting in SaaS business models that look more like the model below. This graph is the one you will clearly see reflected in the public data of companies like salesforce and Workday.

In reality, I am a massive fan of subscription based models for technology. Our last book, Consumption Economics, makes the case for why the entire technology industry will be moving to this model. However, I am gravely concerned that both investors and technology executives are unclear concerning the factors that will ultimately drive sustainable and profitable business models in this new world. A large chunk of deferred revenue, alone, will not guarantee profitability.

Unsustainable Competitive Advantage

This week, I read a scathing article on the demise of Michael Porter’s consulting firm:

What Killed Michael Porter’s Monitor Group? The One Force That Really Matters

If you are in management, you will find this article fascinating. If you are in the habit of using expensive “strategy” consultants, you will find this article both fascinating and discomforting.

Beyond its general insights, this article contains a timely message for technology companies. Michael Porter has argued for years that companies should identify “sustainable competitive advantages” that are hard to replicate. These advantages translate to higher company profits. As this article highlights, in reality, THERE ARE NO LONG TERM SUSTAINABLE COMPETIVE ADVANTAGES. Unless a company has an unfair advantage through government regulation or some other market anomaly, ALL CAPABILITIES can eventually be replicated.

The technology industry has enjoyed very high margins and profits over the past forty years. In mature industries, best in class companies can be expected to generate an operating income of  8% to 15%. In tech, companies are expected to generate operating incomes above 20%. Today, there are tech companies generating operating incomes well north of 30%.

Past success has made tech executives believe their high margin business models should be the perpetual norm.  I would argue these business models are a function of unsustainable competitive advantage.  These business models are a result of consumption models that require customers to make massive up front commitments to technology—and then make it very difficult for customers to change their mind if they are not satisfied with their decision. This approach to technology consumption is not sustainable. Business customers are rapidly exploring new “pay as you go” models designed to match value received with the price paid. In other words, the tech industry is gravitating to more normal market dynamics between buyer and seller.

Our last book, Consumption Economics, has become one of the top five sellers on Amazon in the category of high tech investment:

Amazon Best Sellers

This book defines how tech business models will need to rapidly change as the tech market matures. Many in the industry have read the book. Some readers believe the book is an accurate portrayal of how the tech industry will change. Some readers are convinced their high margin business models will not be changing anytime soon. For all past and future readers of the book, I would repeat these words:   THERE ARE NO LONG TERM SUSTAINABLE COMPETIVE ADVANTAGES.   The consumption models in tech are changing. Get ready.

Pricing Services: Changing the Game

Back in 2008, I posted a framework titled The Pricing Pentagon. The framework identifies the data streams required to enable effective service pricing. That has been one of my most popular posts to date. The framework, originally published in Mastering Professional Services, is becoming more relevant than ever.

TSIA believes technology service organizations will be forced to move off of their traditional cost based pricing models. This change is being accelerated by the trends in technology consumption. As outlined on our book Consumption Economics, we believe enterprises will continue to migrate to models where they pay for technology as they consume that technology. Historically, enterprises paid for all kinds of technical capability up front—some of which they never ended up needing or using. As enterprises subscribe to technology on an “as need basis”, they will begin rethinking how they spend money on the services that surround that technology.

Historically, there were two primary reasons enterprises paid product companies directly for services:

1. Reduce the risk associated with implementing new technology (professional and education services).
2. Receive insurance the technology will keep running (support and field services).

As we demonstrate in our Service 50 index every quarter, most product companies are very adept at making decent margins providing these types of services. We also know from our benchmarking data that most product companies employ variations of cost based pricing models to determine what to charge for their services. Cost based pricing, we believe, will become an unsustainable services pricing model for product companies. Why? TSIA has the following premises related to services pricing:

• P1: Product companies will face immense pricing pressure on service offerings that are required to stand up and maintain a technology environment.
• P2: These traditional service revenue streams will be declining.
• P3: To offset decline in demand, service organizations will need to identify new service offerings (Business Impact Services)
• P4: To offset pricing pressure, service organizations will need to revise service pricing models.
• P5: To enable value based pricing models, companies need to be proficient at defining the business value customers receive from consuming an offering.
• P6: Technology companies currently have weak (or non-existent) processes for defining and defending the business value customers realize by consuming specific services.
• P7: As customers migrate to consumption based pricing models for technology, they will push for “value realization” pricing mechanisms for services.
• P8: Customer analytics will become a key capability in understanding how customers derive business value from technology solutions.

If you believe even half of these premises, you will agree that traditional cost based pricing will be under pressure. Julia Stegman is our lead researcher on service pricing models. We are collaborating on documenting the data streams, organizational capabilities, and business processes service organizations will require as they migrate from “cost based” to “value realization based” pricing models. For more information on this body of work, contact thomas@tsia.com or julia.stegman@tsia.com

Death of 97-2

This post is dedicated to every Services manager that has cursed the following words “According to 97-2….”

Over the years, TSIA has published several papers on the topic of revenue recognition when services are associated with the sale of a technology product.  Ever since FASB published 97-2 (hyperlinl), Product companies have been forced to engage in unnatural behaviors related to bundling services with the sale of a product. Well, that craziness is finally winding out of the technology industry. There are new revenue recognition guidelines that are being rolled out in the technology industry. I have blogged about these pending changes before:

Call to Action for Service Organizations: BIG Changes in Revenue Recognition Rules

These new guidelines are now becoming real for both hardware and software companies. You no longer have to simply take my word for it. These new guidelines are influencing the largest SaaS company in tech: salesforce.com. Below are notes from salesforce’s most recent 10-K. From my vantage point, these notes clearly spell out the death of a terrible practice titled “ratable PS.” Read the notes and tell me if you don’t agree.

In determining whether professional services can be accounted for separately from subscription and support revenues, we consider a number of factors, which are described in “Critical Accounting Policies and Estimates – Revenue Recognition” below. Prior to February 1, 2011, the deliverables in multiple-deliverable arrangements were accounted for separately if the delivered items had standalone value and there was objective and reliable evidence of fair value for the undelivered items. If the deliverables in a multiple-deliverable arrangement could not be accounted for separately, the total arrangement fee was recognized ratably as a single unit of accounting over the contracted term of the subscription agreement. A significant portion of our multiple-deliverable arrangements were accounted for as a single unit of accounting because we did not have objective and reliable evidence of fair value for certain of our deliverables. Additionally, in these situations, we deferred the direct costs of a related professional service arrangement and amortized those costs over the same period as the professional services revenue was recognized.

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2009-13, “Revenue Recognition (Topic 605), Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force” (“ASU 2009-13”) which amended the previous multiple-deliverable arrangements accounting guidance. Pursuant to the new guidance, objective and reliable evidence of fair value of the deliverables to be delivered is no longer required in order to account for deliverables in a multiple-deliverable arrangement separately. Instead, arrangement consideration is allocated to deliverables based on their relative selling price. In the first quarter of fiscal 2012, we adopted this new accounting guidance on a prospective basis. We applied the new accounting guidance to those multiple-deliverable arrangements entered into or materially modified on or after February 1, 2011 which is the beginning of our fiscal year.

The TSIA Cloud 20: Growth vs. Profitability

This Thursday I will be hosting a webcast that analyzes the financial performance of 20 public cloud computing companies. Below is a graph of their quarterly revenue growth:

The quarterly revenue growth (year over year) for these twenty companies is averaging 24%. This comapres with flat top line revenue growth for the broader technology sector as shown ihn one of the guages on the Cloud 20 dashboard I will present in the webcast.

Do growth is great for cloud computing companies. But what about profitability? How are the financial busines models shaping up for this new breed of technology provider? Join me on Thursday to find out:

http://cysalesteam.com/tsia/event/the-tsia-and-pwc-cloud-20

So what is “Premium Support” in the world of cloud computing?

Amazon.com has become a substantial player in the world of cloud computing. Amazon (yes, the online book seller) provides cloud offerings to host web services, storage, and computing cycles for companies of all sizes.

Recently, Amazon announced new pricing related to their support services:

• Amazon Web Services Announces Price Cuts On Premium Support, Free Basic Support For All

When you read the article, it sure feels like a race to the bottom for what cloud computing companies plan to charge for support services. However, the technology industry currently has a model where significant revenues are achieved by providing value added support services to customers. In the TSIA Service 50 data, we know that enterprise software companies, on average, receive over 60% of their revenues from services. Hardware companies receive over 30% of their revenue from services. If cloud computing companies are going to give “premium” service away for free, will these service revenues simply evaporate in the world of cloud computing?

What Amazon Does Offer

Before we say goodbye to all those lovely service revenues, we need to pause. Julia Stegman is TSIA’s VP of Research in the area of Service Revenue Generation. She lives and dies around the best practices for attaching and renewing service contracts to product customers. And she is convinced, more than ever, that attaching value added services will continue to be the lifeblood of economic health for technology companies.

After reading Amazon’s announcement, Julia tried to contact Amazon by phone to ask questions about their new support service offerings.  She summarized the following experience:

• There’s no phone number on their website
• You have to enter an account number to receive the phone number
• Even a “sales question” doesn’t have a phone number — you fill out a web form and it gets routed to someone

Frustrated with the lack of response, she read the information provided by Amazon on their web site regarding their premium support offering deliverables: http://aws.amazon.com/premiumsupport/

After reading the document, she sent me the following summary observations:

The Basic Level Support

• Customer service/billing questions   (that’s a cost of doing business)
• Support forums     (power users do the work + 1:Many creates scale)
• White papers, best practice guides    (1:Many creates scale)
• Access to Technical Support appears very limited.
• Seems you are invited to place a case JUST to resolve an error message through their proactive monitoring capabilities.

Support for Health Checks  

• “Health Checks monitors the health and status of AWS Services and the status of these checks are displayed within the AWS Management Console.
• When a check does not pass, customers will be given the option to open a high priority ticket with Technical Support for assistance.”

Developer Level

• Email only and local business hours with 12 hr response time   (industry average is 4 hours)

Business Level

• Where the deliverables start looking like traditional tech companies with access to Technical Spt via phone, chat & email 24X7.
• 1-hr response.

Best Practice Guidance

• Offered via white papers at the Basic Level and via the Technical Spt team on the “pay for” service levels.

Premium is not Premium

At the beginning of this year, TSIA began benchmarking the service revenue generation practices of technology companies. Part of this benchmarking includes data related to what hardware and software companies provide in level 1 (basic) and level 2 fee based support contracts. The graphs below from Julia compare industry averages to the Amazon offerings.

As you can clearly see, Amazon “free support” and “premium support” look nothing like the basic and premium support offerings of enterprise class technology companies. This is truly an apples and oranges comparison. Enterprise class technology companies are providing a host of capabilities that Amazon is clearly not putting on the table.

Perception Becomes Reality

Even though the support offerings of cloud based providers like Amazon do not look anything like support offerings of enterprise technology providers, TSIA is cautioning all of its members to track these industry comparisons. As more customers move IT infrastructure to the cloud, their service expectations are being reset by the Amazon’s of the world. And what service capabilities they value are being reset. Enterprise technology companies will need to be expert at defining and defending the value proposition of their services. That is, if they want to maintain those services based revenue streams!

Records, Runways, and Tech

This week I am in Silicon Valley, hosting the Technology Services World conference. There are over seven hundred professionals representing 200+  technology companies at this gathering. In my opening keynote, I again warned that the business models of tech providers were on the verge of dramatic change. The new consumption based pricing models will surely force this change. And we can look to other industries to see how new consumption models disrupt legacy business models.

The Record Industry

The chart below was published by Bain consulting and it maps the revenues of record companies over the years.

When the CD was introduced, customers were given a killer advance in listening technology—and they responded by buying tons of albums. However, ever since music became available one song at a time, record company revenues have been declining. Yes, piracy is a challenge. But you have to recognize that record companies had legacy business models built on making, marketing, and selling albums. As a listener, it did not matter if you only liked two songs from that new group. You were forced to purchase the entire album. When songs were decoupled from albums and customers were given the ability to only purchase the songs they really wanted, the business model of record companies imploded. New consumption model. New business models required.

 

The Airline Industry

In the airline industry, low cost carriers have always been around, nipping at the heels of established legacy carriers. However, the rules of consumption changed for the airline industry with the advent of web sites like Expedia. Suddenly, consumers were able to see the price being offered by all carriers, side by side, to fly to a location. To compete in this model, legacy carriers like American Airlines were forced to strip out various services that were previously bundled in the cost of the ticket. In this way, American could at least stay competitive on these web sites when customers shopped for an air fare. The challenge is that American did not strip out enough cost. They still needed to charge for these services. The graph below shows how much American charges for add on services vs. low cost carrier Jet Blue. As you can see, American is charging much more for the same services.

If you look at the business model of American vs. Jet Blue, you see that American spends more money (as a percentage of revenue) on only one category: labor. Those higher labor costs drive American to charge higher rates for the same services.

Charging more for the same thing is never a winning strategy. The brutal lesson from the airline industry: Your higher labor costs are not the customer’s problem.

When Consumption Models Change

The consumption models in the technology industry are changing at a high rate of speed. In my opening keynote, I referenced the dramatic pricing move made by Adobe. Adobe software that previously cost $2,600 per user is now available for $50 a month. At some point, the Adobe management team realized they had no choice but to adopt their business model to align with the new consumption models in technology. At some point, every technology company will need to cross that same bridge. Cross that bridge, or follow the record companies and airline companies that did not truly change their business models when customers changed their pattern of consumption.

Are You Growing at 192% Year Over Year?

For the past year and a half, TSIA has been warning legacy product companies that cloud computing will become the consumption model of choice for many companies, both large and small. So from the TSIA perspective, this is a conversation of “when” not “if.” When will cloud computing options begin to disrupt your current business model?

Market research firms like IDC and Forrester predict how fast various markets will convert to cloud computing models. This is not what TSIA does. We are focused on how this shift will impact the business models and service models of technology providers. So we don’t try to answer the “when” question for companies. Having said that, I read an article today that simply blew my mind and is directly related to the “when” question.

Amazon.com offers cloud based storage and web service offerings. They  just announced the growth rate they are experiencing on these services:

 

Year over year growth of 192%. Are there any products or services in your current portfolio currently growing at 192%? The TSIA Service 50, fifty of the largest providers of technology solutions today, grew top line revenues at a tepid 6% from Q4 2010 to Q4 2011.

And the tongues are wagging about this growth of S3:

“This is the largest storage system in the world bar none; there isn’t anything like it anywhere else that I’m aware of unless it’s some secret government/NSA vault.”

“I don’t understand how people can’t see this kind of thing and just have their jaw hit the floor. People are paying for this. At this rate they will have 2 TRILLION objects in another year and it will be a $600M/year business.”

• Randy Bias, co-founder of Cloudscaling

 

“First, broad based adoption driven by consumerization of IT. Second, the shift from transaction to engagement – we have social, mobile, analytical, and other unstructured data. Third, true elasticity has come to fruition as the promise of the cloud gets delivered. People are taking to the cloud because the tools are easy to use and they don’t have time or money to provision expensive servers. Instead they are using elasticity, which was the original premise of AWS. We could see it happening last year but this leap in growth is tremendous.”

“Amazon has established itself as one of the leading contenders. The barriers of entry are high. Very few folks can afford to build the data centers, the software infrastructure, and momentum to be profitable. Amazon is in the same league as Google, Microsoft, IBM, etc. The only other folks that could do it if they woke up are the telco’s – but we’ve all been telling them that for years. They haven’t paid attention.”

• Ray Wang,  ReadWriteWeb

So I don’t know exactly when cloud computing will impact your business model. But I will continue to argue it is a question of “when” and not “if.”

 

 

 

S50 Webcast

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.

Register for the S50 Webcast

I Hope I am Wrong

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.