Mach 2, 2014 – SaaS: After the Levee Breaks – Competition in Software

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Web-scale cloud platforms, leveraging massive consumer applications, have dramatic cost and performance advantages over private data centers, stemming from their scale, scope, superior design, and world-class computer science skills. These advantages, which already allow the top cloud operators to deliver 50-75% lower costs to customers vs. the all-in costs of in-house solutions, are growing wider with time and are rapidly separating AMZN, GOOG and MSFT from smaller would-be rivals. As we have often noted, these dynamics are troubling for traditional data center technology vendors, and are likely to be deflationary for IT budgets in general. Low cost, high performance cloud hosting also greatly lowers the barriers to entry for SaaS application developers – opening the door to innovation and competition in enterprise applications, pressuring SaaS pioneers with older architectures, and posing an existential threat to traditional application vendors. Success in SaaS will come from innovation, execution, and scale economies rather than customer lock-in, and product life-cycles will be shorter than in the last 30 years of the software market.

The cloud offers dramatically lower costs than traditional data centers. Public cloud distributed data center platforms have huge cost and performance advantages vs. private data centers based on several factors: 1) Use of commodity components vs. value-added configured systems; 2) Extraordinary power efficiency; 3) Much higher utilization; 4) Higher system availability; 5) Superior backup and redundancy; 6) Flexibility, scalability, power and convenience; 7) Substantial economies of scale. All-in comparisons give the top cloud hosts a 50-75% cost advantage vs. in-house enterprise data centers, and with cloud pricing dropping at roughly 30%/yr, the gap is rapidly widening. These factors are a particular advantage for AMZN, GOOG, and MSFT, which employ cutting edge data center design, sophisticated software, and massive scale, driven by demanding consumer cloud franchises. As rivalry intensifies, service offerings will expand and prices will continue to drop, squeezing smaller competitors. Currently, IaaS prices yield 50-75% cost benefits vs. typical in house all-in costs, a gap that is widening.

SaaS applications offer advantages beyond cost. By bundling the costs of the data center, SaaS vendors offer substantial savings vs. the all-in costs of running an application in house. Beyond these savings, most of which derive from cloud hosting, SaaS applications offer significant functional benefits. First, SaaS is scalable and predictable – costs grow proportionally to use on a transparent basis. Second, SaaS reduces complexity – expert user support is included, upgrades are automatic, costless and painless, and expert system/software maintenance is included. Third, access to SaaS applications is ubiquitous and availability is superior. Finally, inherently mobile SaaS applications tend to be far more easily implemented on mobile platforms. With switching costs falling rapidly – most SaaS vendors have sophisticated transition tools, support traditional data formats, and mimic familiar user interfaces – and incumbent stoked security/reliability fears proving unfounded, adoption of SaaS is accelerating.

Traditional data center spending has peaked. While investment on cloud data centers is exploding, the design of the most sophisticated operators excludes the value-added systems and software infrastructure that made up the bulk of enterprise spending during the PC era. Meanwhile, enterprise IT departments are scaling back internal investments as their focus shifts to cloud hosting and SaaS applications. Spending in every major data center category has sharply decelerated over the past three years, with even the most robust categories, like storage systems, on a trajectory toward decline. While the savings from cloud solutions may yield some elasticity in overall demand, the price differential assures that the net effect will be extremely deflationary for IT budgets, with the traditional tech players – HP, IBM, EMC, Cisco, Oracle, SAP, and others – on the losing end.

Lower barriers to entry may leave SaaS margins below traditional software. The rise of AWS and the aggressive response from MSFT and GOOG will change the competitive dynamics of the SaaS market. Historically, SaaS vendors have required substantial upfront investment in building out data centers ahead of product launch – CRM, N, et al were built this way. IaaS allows new players in with minimal capital investment, bringing a flood of new would-be entrants to the market. However, where SaaS vendors can differentiate their products, we see ample opportunity for profitability. We see four main paths to differentiation – 1) functional innovations; 2) community-based network effects; 3) cross-product ecosystem synergies; and 4) system learning. Loss of customer switching friction will pressure margins across the industry, particularly players carrying private data center infrastructure, as newer rivals leveraging increasingly low cost web-scale cloud hosts are able to undercut established prices based on fundamentally lower COGS.

Life cycle business model is very different for SaaS. The subscription model spreads SaaS sales recognition fairly evenly through the life of a customer relationship, while expenses are front end loaded. For companies in growth mode, even at the size of Salesforce.com, this severely squeezes reported operating profit. However, as customer contracts age, they should grow continually more profitable, without the periodic sales expense of pushing upgrades, and, as the relative investment scales back in a normal growth environment, operating margins will rise. Ultimately, SaaS profitability will depend on product differentiation, and leveraging data center scale advantages. This last factor will be a strong advantage for IaaS operators competing in SaaS apps. We do not expect SaaS only players to approach the 30%+ margins earned by software leaders in the last cycle, as it will be difficult for them to make margins on the infrastructure costs embedded in their business model.

Invest in sustainable differentiation. Differentiation will be on the basis of functional innovation, network effects, ecosystem effects, and system learning. We are concerned for the traditional application leaders, such as Oracle, SAP and IBM. For the most part, their SaaS initiatives are compromised by the imperative to sustain the profitability of the classic franchises – a dynamicwell described by Clayton Christenson in “The Innovator’s Dilemma”. We are cautious about many of the SaaS pioneers – e.g. N, CNQR and others – concerned that their in-house data centers will struggle to remain competitive with solutions hosted on the big three IaaS platforms. We are enthusiastic about differentiated SaaS players that have embraced 3rd party hosting – i.e. WDAY. Finally, we expect the IaaS market to break into haves and have nots, with AMZN, GOOG and MSFT on track for long term dominance.

For our full research notes, please visit our published research site.

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