Archive for the ‘Service Business Models’ Category

B4B has Begun

September 13, 2013

Sorry I have been so silent lately on this blog. I have been heads down collaborating on a new book titled B4B. The historical business models of technology providers are imploding in front of our eyes–and this is why we needed to write this book. What do the new business models look like for traditional hardware and software companies?

B4B hits the streets next month at our Technology Services World conference in Vegas.

If you are interested in reading the first chapter, visit: http://www.tsia.com/members.html

Meanwhile, the real world examples of how the concepts outlined in B4B just keep popping. Cisco has always had an economic engine centered on product revenues and margins. As we discuss in B4B, that economic engine is commoditizing. Companies like Cisco will need to transition their economic engines. And the transitions have begun:

The move reflects two stated priorities of Cisco CEO John Chambers: to bolster Cisco’s overall security business and to rapidly expand Cisco Services operation in an effort to become the world’s largest IT company. In other words, Chambers wants to transform Cisco into an IBM with networking roots.

from Cisco adds Security Practice

The problem, however, is that Cisco (or any other hardware company) doesn’t really want to become another IBM. Have you looked at IBM’s top line growth numbers lately? No, product companies like Cisco need to become something very different than what IBM is today. And that is why we wrote the book. Can’t wait for Vegas.

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Scrutiny on the SaaS Business Model

July 24, 2013

Every since TSIA started our tracker of publicly traded cloud computing companies (The TSIA Cloud 20), I have been questioning the financial business model of SaaS companies:

Today, a colleague pointed me to a blog entry that also finds reasons for concern:

Read all three of these blog entries. Is there something we are missing? Or, as TSIA would argue, will SaaS providers need to fundamentally change the way they operate in order to achieve long-term profitability?

 

Double Click on the SaaS Business Model

April 17, 2013

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.

Workday

 

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.

SaaS Theory

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.

SaaS Reality

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.

PS Margin Myths

March 20, 2013

I read a blog entry today from a venture capitalist that made me wince:

One of the Biggest Mistakes Enterprise Startups Make

In the post, he is making the argument for why software startups need to invest in Professional Services. I am in line with the majority of his reasons. Until his last point:

And finally, the most obvious argument is an economic one.

It’s true that professional services have a lower margin (say 45-55% gross margin) than software (typically 85-95% gross margin) and professional services business are inherently less scalable.

So I’m not endorsing your building your entire company around professional services (although I think that’s a fine strategy for many non VC-backed companies) but rather not to avoid it.

Let’s say you can do $1 million in software sales in your first year of selling delivering $850,000 of gross margin. Let’s say you can supplement that with $1 million in professional services revenue at $500,000 gross margin.

Need I point out that the $500,000 is still profitable revenue that can contribute to your central costs of running your business?

I have been involved in benchmarking embedded PS organizations for the past seven years. I know exactly what best in class financial performance looks like for PS organizations within software companies. I can tell you that both project margins and overall PS profitability have been steadily improving year over year. But I can also tell you, that on average, embedded PS organizations are not generating 50% gross margin on projects. And they surely are not dropping 50% of their revenues to the bottom line to cover other company expenses.

The logic in this blog entry is based on grossly inaccurate assumptions–and that is what makes it so dangerous. I pity the poor manager put in charge of PS for a company that this venture capitalist has invested in. The expectations of the economic role of PS will be based on napkin math, not financial realities.

Building and scaling a project based human capital intensive business is hard. Having investors that do not understand the financial realities of the PS business model make success almost impossible.

 

Framing Managed Services

September 10, 2012

Every year TSIA benchmarks the growth rate of service revenues in over one hundred major technology companies. From this data, we know three things:

  • For some original equipment manufacturers (OEMs), Managed Services has already become a core source of revenue and profits.
  • For other OEMs, Managed Services become a new, hot services offering.
  • On average, Managed Services is the fastest growing service line for hardware and software companies that have established support and professional service businesses.

So Managed Services is becoming an ever more important component of the economic engine for OEMs. The real challenge is to truly understand what is actually in this fast growing service line.

I have spent the past three months speaking with TSIA members about their Managed Service businesses. It is clear the lines between Managed Services and SaaS have blurred.  CRN published an article titled Managed Vs. Cloud Services attempting to clearly define the difference between Managed Services and SaaS. I can tell you, the OEMs are not very concerned about following these definitions. In fact, many OEMs have Managed Service offerings that would comfortably fall into Gartner’s definition of SaaS.

To add to the confusion, the lines between Outsourcing and Managed Services have also blurred. Brainstorm states that the difference between Outsourcing and Managed Services is the length of contract. Sorry, OEMs are cutting very complex, multi-year deals that are being classified as “managed services.”

So, why does all this matter? Because at some point in time, CFO’s at OEMs will want to understand how their Managed Services business is performing. They will want to benchmark growth and profitability. But benchmark against what? If you own a Managed Services business, this question will become critical at some point in time.   To help address this dilemma, TSIA has published a new white paper:

Service Insight: Framing Managed Services

Enjoy!

Records, Runways, and Tech

May 7, 2012

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.

The Downward Drag of Travel Expenses

February 28, 2012

The travel time and travel expenses associated with delivering service engagements seems like such a mundane topic. Yet, the nuances surrounding travel time never seem to cease.

Billing for Travel Time

Way back in October of 2008, I posted the following question on behalf of a TSIA member:

Do technology professional services organizations typically bill customers for the travel time incurred by delivery consultants related to the customer’s project?

The current polling results from that entry shows that roughly 65% of service organizations do indeed bill customers for various levels of travel time. So this is clearly the common industry practice.

VSOE and Travel Expenses

In November of 2008, another TSIA member was curious how service organizations were handling VSOE compliance when customers requested that travel expenses be covered in the daily rate of the resources. I posted the following polling question:

If customers request you include travel expenses in the daily rate, your service organization:

  • A. Includes those data points when calculating VSOE compliance.
  • B. Excludes those data points when calculating VSOE compliance.
  • C. Creates two VSOE rate schedules–one with travel expenses and one without.
  • D. Other

Here, there is no common industry practice. Currently, 50% of the respondents create two distinct VSOE rates (option C). However, 50% of respondents do something else.

Avoiding the Downward Drag of Travel Expenses

Now, for another question asked by a TSIA member on this topic of travel expenses:

Typically we are able to bill back approximately 90% of the Travel and Lodging incurred on client funded projects which is accounted for as revenue. However, there is no margin on this revenue. This zero margin revenue results in a 5%- 8% drag on our delivery margins. If we were able to take this as cost offset our operating margin would improve in a significant manner. We are keen to find an alternative approach to dealing with travel. Are any other service organizations handling travel expenses differently to avoid the negative margin implications?

I have to admit, I have never been asked this question before. Perhaps the accounting rules prevent any creative alternatives. But my interest has been peaked. The above inquiry actually spawns two questions:

  1. Is there a way to keep travel expenses from diluting margins?
  2. Are service organizations marking up travel expenses?

If a service organization is making margin on travel expenses that is not dilutive, they may want to keep the travel expenses on the service books! So, here are two quick polls. Take a moment and let me know what you are doing. If you have an interesting insight on this topic, please feel free to comment below.

S50 Webcast

January 24, 2012

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

The SaaS Business Model

September 18, 2011

In the recent Cloud 20 webcast I hosted, we discussed the topic of the financial business model that SaaS providers will mature into. Right now, we know that SaaS providers that are public do not have business models that are as attractive as the business models of successful license based software companies. In the TSIA Service 50 index, we track the public data of many of the leading established license based software companies. In the graph below, we compare the business models of SaaS companies in the Cloud 20 to the average of business models of software companies in The Service 50:

I have made the above observation in multiple forums over the past two years. There is nothing quite as special as the profitability of a mature license based software company. And to date, SaaS companies have not proven they can be anywhere near that special. But let’s move the conversation one step forward.

The Target SaaS Business Model

Right now, everyone I speak to regarding the SaaS business model believes it is still maturing. “Hey, most of these SaaS providers are in high growth mode as they grab market share. The mature business model will emerge after the land grabs.” OK, I can buy into that assertion. So as SaaS becomes a more and more popular mode for consuming software, how will these SaaS business models mature? We know that a “healthy” enterprise software company generates gross margins north of 80%, spends less than 40% on Sales, Marketing, and G&A, 15% on R&D, and generates a profit north of 20%. What will a “healthy” SaaS business mode look like? The image below shows the actual business models of some of the SaaS companies we track in the Cloud 20 and places them next to a hypothetical target business model for successful, mature SaaS companies.

As the image shows, even large SaaS provides like salesforce have a long way to go before they approach a business model that looks even remotely interesting from a profitability perspective.

The Levers of the SaaS Business Model

In our recent webcast on The Cloud 20, I asked the attendees where the greatest opportunity lies for SaaS providers to improve the performance of their business models. Will they be able to reduce the
percentage they spend on R&D? Will sales and marketing expenses trend smaller as brands become larger? Or perhaps G&A will reduce as a percentage of revenues as these companies grow. The audience was very clear in their response. They believe the greatest opportunity for SaaS providers to improve the SaaS business model is to improve the margin on subscriptions. That makes good sense. Except, a majority of the audience also believed that average subscription prices for SaaS offerings will trend lower, not higher, over time. This means the entire SaaS business model hinges on the volume of incremental subscribers outpacing both the price pressures on subscriptions and the cost to serve more and more diverse customer needs. This may indeed be the scenario that plays out for SaaS. However, that is not how it has played out in other IT markets. Think PCs. As the capability and complexity of each unit went higher, the cost per unit went lower and lower. The result has been a very low margin low profit business model for the PC manufactures, regardless of the market share they command.

What is the target business model for SaaS providers? Based on the rapid adoption of cloud based software models, we will find out shortly enough. I’m just not sure those of us in the IT industry are going to like the answer.

TSIA Cloud 20 Webcast: The Financial Model of Cloud Providers

September 5, 2011

Over the past three months, the TSIA team has been heads down putting the final strokes on our latest book: Consumption Economics: The New Rules of Tech. This book reveals the fundamental impact cloud consumption models will have on technology providers. One aspect of that impact will be the shape of their financial models. How much margin will hardware and software companies make as cloud computing grows? How much will these companies need to spend on markteting their services?

Join me this Thursday as I review twenty cloud computing providers and analyze the financial models of the future:

http://webcasts.tsia.com/home/listing/tabid/64/listingkey/139/the_tsia_cloud_20.aspx