Revenge of the Software Customer

According to technology analysts AMR Research, more than 80% of customer relationship management (CRM) software deployments either don't add value, encounter user resistance, or fail outright. Such disappointment has made CRM customers vengeful and ready to support the growth of the software-as-a-service (SaaS) market, which includes customer-relationship specialists such as Salesforce.com (NYSE: CRM  ) and RightNow Technologies (Nasdaq: RNOW  ) .

With SaaS, software is transforming from a product to an on-demand service, whereby software is delivered over the Internet in return for a fixed fee. Unlike the traditional software license model, there are either no up-front fees or very low ones.

Soothed by the business case
The business case for SaaS customers is soothing -- it's especially compelling for small and mid-sized businesses, which lack the infrastructure and large user populations of their bigger brethren. But the case is equally convincing for all company sizes.

  • It saves a lot of money. A Yankee Group study found the total cost of operating an on-demand software package is less than half that for an equivalent system bought the traditional way.

  • It's quick. With SaaS, software can be deployed in days and weeks, rather than six to 18 months with traditional license-and-install software.

  • It allows IT departments to offload the delivery and maintenance of software applications. The SaaS firm, not the customer, invests in the technology, hardware, and ongoing support services.

  • It lowers risk. Small and mid-size companies live in fear of the failure rates of large-scale enterprise resource planning (ERP) and CRM implementations.

  • It's sound economics. In the traditional model, the supply and demand for features usually don't match. Companies buy software loaded with bells and whistles they don't need. In a 2005 IDC survey of 250 IT execs, companies said they use just 16% of the software they buy.

  • It produces healthier relationships. The SaaS provider earns its return over the term of the relationship, rather than front-loading with a license sale.

So SaaS is great for customers. What does it mean for investors in the business software, services, and hardware sectors?

The SaaS model and investment opportunity
SaaS changes the way a software company designs its products and how it delivers them, but most of all, it changes its economics. A quick tour of a typical SaaS income statement is instructive. At the top, revenue is initially smaller, but it's also much more stable and predictable, because customers make regular subscription payments instead of large up-front license fees and professional service fees. And these payments are annuity-like, since they are locked into two- to four-year contracts. The cost of revenues should also improve, since there is less investment in professional services because of rapid deployment and Web-based delivery. A fully developed SaaS company should produce gross margins comparable to those of the traditional software licensing model, but without the margin drag of professional services. Operating expenses also drop, because an SaaS company can support many customers on a single, shared application and infrastructure.

The investor opportunity in SaaS remains attractive and will continue to develop in 2007. There are at least three key themes to think about. First, Salesforce.com has matured into the dominant pure-play SaaS provider, and its AppExchange platform moves the company well beyond CRM applications. In addition, the company is successfully reaching the large-company market, with clients including Cisco, ADP, and Merrill Lynch.

Second, as SaaS spreads to non-CRM functions, it creates new investment opportunities. Webex Communications (Nasdaq: WEBX  ) helps road warriors stay at home by offering Web conferencing and collaboration tools. Valuation of Webex remains calm compared to Salesforce -- it trades at a price-to-sales ratio of 4.5 and an enterprise value-to-EBITDA ratio of 12, as opposed to Salesforce's respective ratios of 10 and 94. According to SaaS expert Michael Mankowski at Tier I Research, the human capital management (HCM) application should be hot in 2007, and publicly quoted companies in this space include Kronos, Kenexa, and Taleo.

The final theme to consider is that of acquisitions and consolidation. In 2006, Intuit (Nasdaq: INTU  ) acquiredDigital Insight (Nasdaq: DGIN  ) , and such transactions will likely continue.

SaaS affects hardware and IT services, too
SaaS is expected to grow to capture more than 25% of the $200 billion business software market by 2011, according to technology analysts Gartner. SaaS also accelerates some visible industry trends.

The first trend is that large enterprise software companies are treated as value, not growth, investments. After a rugged, high-growth youth, large software companies are mellowing into value stocks. They earn stable recurring maintenance revenues (40% of total revenue is typical) from large installed customer bases and have growing piles of cash. Understandably, to protect this business, they are taking a measured approach to expanding their SaaS offerings. Also, software companies tend to be lightly leveraged, which, coupled with the steady maintenance revenues, makes them targets for the merchants of debt. Witness the purchase of SunGard Data Systems by a consortium of private equity firms for $11.3 billion.

Second, SaaS may contribute to harder times for hardware sellers who don't shift themselves to an on-demand model. Companies do not need a lot of gear with SaaS: A Web browser and a broadband connection is the entire IT infrastructure needed. On the other hand, of course, SaaS companies do need others to manage their infrastructure -- data centers, servers, storage, and middleware -- and they need service delivery platforms.

Third, the traditional model of selling enterprise software -- IT-service firms that serve as a sales channel, in return for a consulting engagement to implement the software -- may suffer. Companies such as IBM (NYSE: IBM  ) and Accenture (NYSE: ACN  ) are responding by stressing industry expertise and cutting integrator partnerships with the larger SaaS players, such as Salesforce.com.

SaaS expands across functions and businesses
The base case for investing in SaaS companies is the ability to access a new growth opportunity -- the 50 million small- and mid-sized companies in the world that cannot afford or fear the risk of enterprise-class software. As SaaS matures, the opportunity to extend to large companies and across functions beyond customer relationship management creates the most important software growth opportunity for 2007.

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This article was originally published on June 6, 2006. It has been updated.

Intuit and Accenture are Inside Value recommendations. Take a free test drive of Inside Value to see the full market-beating portfolio.

Fool contributor John Finneran writes and advises on increasing the financial value of technology. He is currently ranked 26 out of 19,225 participants in Motley Fool CAPS and does not own a position in any of the companies mentioned. The Fool has a disclosure policy.


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