Subscription Software Is Sweet

We heard it back in the 1990s: The software industry will move from selling one-off licenses to subscription licenses. Now, with software sales down, we're hearing the same mantra again in 2004, and Fools should listen up.

The reasoning is simple: In a maturing industry, selling licenses through a subscription model bolsters vendors' revenues. Paying a monthly fee to use software is cheaper and less risky than buying software outright and hiring staff to support it. So, in harder times it's easier for corporate customers to swallow the subscription model. At the same time, vendors spend less on high-cost salespeople and invest more in serving customers with call centers and technical support. Those higher revenues and lower costs go straight to the bottom line.

Of course, investors will like the smoother, more predictable earnings profile that the model offers. The customer pays for licenses over time, and the software vendor recognizes revenues over the life of the contract. Software is no longer akin to a big piece of capital equipment, purchased at a high cost for long-term use. Instead, it becomes like a basic service, used and paid for every day. The subscription model levels out peaks and valleys in income and cash flow that hit software valuations.

Just look at its impact on Wind River Systems (Nasdaq: WIND  ) . For the maker of software systems for communications, automotive, and other devices, subscriptions are a saving grace. Wind River's total revenue fell by almost 9% in the fourth quarter. But subscription revenues jumped from $1.3 million to $6.8 million, keeping Wind River Systems from slipping into the red for the quarter.

For companies that sell products based on "open source" software, subscription-based support is the natural way to go because those companies cannot depend on proprietary licensing for revenue and must rely on support services. Linux open source specialist Red Hat's (Nasdaq: RHAT  ) fourth-quarter revenue growth came mostly by way of subscription sales, which jumped 79% over the prior year's fourth quarter.

Sun Microsystems (Nasdaq: SUNW  ) , struggling to keep revenues and earnings up, has overhauled its software strategy for more subscriptions. Sun says it will charge customers a per-user fee for some of its software, eliminating complex pricing that applied to hundreds of different products.

Another stock benefiting from subscription sales is Synopsys (Nasdaq: SNPS  ) . The company makes software that enables microchip makers to design complex integrated circuits. Now into its third year of subscription sales, Synopsys has lowered its prices by 15%. More than 80% of the company's bookings now come from subscriptions. With the chip business finally coming out of a painful cyclical slump, Synopsys is well-positioned to squeeze more profits via its well-formed subscription sales model.

Market research group IDC projects that about half of software vendors will move from a one-off license payment system to a subscription-based model in the next 12 months. But don't get too carried away. For the time being, the old model will probably remain the norm. Heavy hitters like Microsoft (Nasdaq: MSFT  ) and Oracle (Nasdaq: ORCL  ) , while they pay lip service to the subscription model, have big interests in maintaining the status quo.

Discuss the subscription software model and its benefits with other Fools on the Red Hat discussion board.

Fool contributor Ben McClure hails from the Great White North. He doesn't own any shares of companies mentioned here.

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