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.

Technology Service Trends: 2012

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:

• Cloud Computing: This is the ongoing trend of hardware and software capabilities migrating from local locations to centralized locations. These centralized, “clouds” can easily be accessed from anywhere. This migration began over a decade ago with software as a service models (Saas), but has continued to expand to now include infrastructure as a service (Iaas) offerings like Amazon.com’s storage offerings and platform as a service (Paas) offerings like salesforce.com’s  AppExchange.
• Consumption Based Pricing Models: This is the trend where customers pay only for the technology they are consuming, instead of investing in capacity that they will grow into. This pricing model is presenting itself in everything from storage, services, software features, and even processor features that can be turned on well after the initial purchase. This new pricing model changes the revenue streams for technology providers.
• Consumption Analytics: In the world of consumption economics, technology companies must understand what product capabilities customers are actually consuming (or not consuming). This responsibility is also falling to the services organization. How can technology companies better track actual customer usage behaviors? What new revenue generating offers can service organizations create based on this data?
• New Go to Market Models: Historically, product companies have leveraged a go to market model that leads with product functionality and leans on partner capabilities. In a post cloud/utility landscape, “product features” will weigh much less than “service features” in the decision process of customers. This means product providers will have to transform their selling motion to truly be services led. For a majority of product companies, this is not a minor transition. 
• Mobility Computing: Mobility computing is where the access to IT capabilities no longer occurs through traditional desktop machines that are loaded with processing power, memory, storage, and are tethered to the corporate network. Instead, users expect to access IT capabilities from any location and from a myriad of devices, large and small. TSIA partner PWC has observed that companies need to migrate from “email cultures” to “app cultures.”  If you stop to think about that simple concept, the ramifications are immense.  The explosion of smart mobile devices and “apps” is forcing technology solution providers to rethink everything from solution design to security to price points for solutions.
• Social Media: This is the phenomenon of communities leveraging technology platforms to share experiences and insights. For technology providers, social media is not about high school friends reconnecting on Facebook. Social media is connecting customer communities in ways that technology providers cannot control. This trend is forcing tech companies to rethink strategies related to user communities, support models, and knowledge bases.
• Rise of New Major Markets: Finally, it is very clear that as the world emerges from the most recent global recession, some of the greatest economic opportunities will not be represented by the traditional tech stronghold markets of North America and Europe.  China, India, and Brazil are but three examples where overall economic growth is expected to far outpace that of the U.S. and Europe. Historically, technology companies have taken products and services optimized for North America, and migrated those offerings to other markets. To maximize growth opportunities, tech providers will need to launch their new products and services with the new major markets in mind—from the beginning.

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.

The Commoditization of Complexity

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)

• Food products and fisheries (e.g. grains, tea, meat, fish);
• Agricultural non-food products (e.g. cotton, rubber, tobacco);
• Ferrous metals (iron, steel, etc.);
• Non-ferrous metals (tin, gold, etc);
• Industrial raw materials (e.g. non-metallic chemicals); and
• Energy (e.g. coal, oil)

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:

• Complex document management solutions from companies like Xerox and Ricoh
• Complex network technologies from companies like Alcatel-Lucent and Ericsson
• Scalable, reliable storage technologies from companies like EMC and IBM.

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:

1. Commodity Engines: These will be tech companies that will be forced to compete on price and volume. Think Acer PCs. But also think of the standard CRM offering from salesforce. A vast majority of tech companies will end up on this square.
2. Differentiated Engines: These will be tech companies that provide differentiated technology and or service capabilities.  The differentiation will have to be very compelling. Today, this is someone like a VMware. But this is an every shrinking number of tech companies.
3. Consumption Engines: These will be tech companies that provide the technology at commodity prices but learn how to commoditize revenues based on actual customer consumption. Think Apple and their MP3 players. Think LinkedIn. Think XBOX.

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.

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.

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.

Register for the S50 Webcast

 

 

Service Country Profiles: China

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.

Defend and Protect

Today, in the opening plenary session at TSW conference in Las Vegas, I made the argument that the high tech business models we have optimized over the past twenty years are perhaps the most profitable business models around.

Oil companies like ExxonMobil and high margin lingerie makers like Victoria Secrets clearly have profitable business models. Yet, those business models pale in comparison to the profits generated by a well oiled enterprise technology business model. In the keynote, I shared the graph below which compares the operating profits of Oracle and Cisco to those of ExxonMobil, The Limited (the parent company of Victoria Secrets), and retailer Amazon.com.

Mature tech companies are generating profits that far exceed most industries. At TSIA, we believe this business model will be changing dramatically in the next three to five years. We outlined these changes in Consumption Economics. But for now, tech companies (and their service organizations) should employ every practical tactic possible to defend the existing business models as long as possible. The profits from the current model will be sorely needed to fund the painful transitions ahead.

In the keynote, I outlined tactics that Professional Services, Education Services, and Field/Support organizations can pursue today to help defend the current margin structures of these businesses. To be clear, I am not suggesting service leaders put their head in the sand regarding the pending changes that will be impacting the industry. I am encouraging service leaders to be aggressive and creative in creating runway for the changes that will be required to occur in almost every tech business I have ever benchmarked.

The next three days in Vegas will be a fantastic opportunity to grab and gather every trick and tactic being employed in the industry. Take advantage of the opportunity! Engage with your peers. Engage with the TSIA Research staff. Engage with herd of TSIA partners in the Tech Expo. All of these folks have insight. And one of them may provide that one tidbit that helps you defend that beautiful tech business model you currently have.

Consumption Economics at the Processor Level

Well, we are getting down to the short strokes regarding our preparations for TSIA’s industry conference this month in Las Vegas. At this conference, we will be presenting concepts from our latest book: Consumption Economics: The New Rules of Tech.

One of the key premises of the book is that the economic model for technology companies will dramatically change with the advent of cloud and subscription based consumption models. I won’t go into all the details here, but envision a world where technology companies make money per feature or per transaction as customers actually consume technology. This is very different from the current model where customer’s pay a chunk of money up front to purchase hardware and software. The difference in these two models is summarized in the image below.

We have been talking to many product companies about this move to a consumption based revenue model for the IT industry. Some are already seeing the shift. Others are skeptical. Well, I stumbled on a perfect example of consumption economics playing out at the processor level. Intel offers a processor upgrade service that allows customers to download firmware updates that unlock better performance. Here is how the service is positioned on the Intel web site:

Intel Upgrade Service provides your end customers with easily upgradable hardware so you can deliver the capabilities they want as they are needed.  Budgets are tight and many small and medium businesses may not be able to justify a fully-featured system right now, yet would  like to have that option in the future.  Upgradable hardware is the answer.  When your customers purchase a PC with qualifying Intel CPU  and Chipset, they have a system that can grow to match their needs, and you have an opportunity to provide more services to that customer over time.

So, the next time you upgrade your O/S and it grinds your system to halt, you don’t have to throw away the machine or throw out the processor–you may simply need to download an upgrade from Intel for a few bucks. This is the perfect example of consumption based economics in the world of technology.

Join us in Las Vegas this month as we discuss how consumption economics will impact the business models of product companies. It is gonna be a bumpy ride…