If David Blaine is looking for a new stunt, he might consider implementing a customer relationship management system (CRM) -- it ought to be better than living in a tank of water for a week. According to technology analysts AMR Research, more than 80% of CRM software deployments either don't add value, encounter user resistance, or fail outright. Such highly dangerous activity has created the software-as-a-service market, led by customer relationship specialists such as Salesforce.com (NYSE:CRM) and RightNow Technologies (NASDAQ:RNOW).

These last few years have seen software transforming from a product to a service. The trend is called software as a service (SaaS), or the on-demand model. This model delivers software over the Internet, in return for a fixed fee per user, per month, or per use. Unlike the traditional software license model used by companies like Microsoft (NASDAQ:MSFT) and Oracle (NASDAQ:ORCL), there are no (or very low) upfront fees.

Business case for customers
The business case for customers is compelling, especially strong for small and midsized businesses, which lack the infrastructure and large user populations of big companies.

  • First, 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.
  • Second, 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.
  • Third, it allows IT departments to offload the delivery and maintenance of software applications. The SaaS firm invests in the technology, hardware, and ongoing support services, freeing the customer from those expenses.
  • Fourth, it lowers risk. Small and midsize companies live in fear of the failure rates of large-scale ERP and CRM implementations.
  • Fifth, 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 2005, IDC surveyed 250 IT execs, finding that companies believed they use just 16% of the software they buy.
  • Finally, it produces healthier relationships. The SaaS provider earns its return over the term of the relationship, rather than front-loading costs via a license sale.

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

Investment opportunity
SaaS changes the way a software company designs its products, how it delivers them, and most of all, the economics underlying the entire process. A quick tour of a typical SaaS income statement is instructive. At the top, revenue is initially smaller, but much more stable and predictable, because customers make regular subscription payments instead of large up-front license fees and professional service fees. These payments are annuity-like, because they are locked into two-to-four-year contracts.

The cost of revenues should also improve, since SaaS requires less investment in professional services, thanks to its rapid deployment and web-based delivery. A fully developed SaaS company should produce gross margins comparable to the traditional software licensing model, but without the margin drag of professional services. Operating expenses also drop, since an SaaS company can support many customers on a single shared application and infrastructure.

The SaaS opportunity is still in its early stages. Two of the best-known companies, Salesforce.com (with a P/E of 128 for the trailing twelve months) and RightNow (a P/E of 87) are stock stars. Both companies sensibly focused on offering customer relationship management and service functionality to small and midsized companies. This is base camp for the SaaS investment opportunity. Now they are expanding to large customers (Salesforce's largest customer is ADP) and a range of functions. For the adventurous, growth may be available at a more reasonable price in several small public companies built around the SaaS model. The largest is Digital Insight (NASDAQ:DGIN), which offers online banking technology as a service to small banks and credit unions. Taleo is applying the SaaS model to recruiting, while Vocus is doing the same for public relations. There's also an on-demand digital marketer, WebSideStory (NASDAQ:WSSI) -- recipient of Gartner's highest rating for being "solid providers of strategic products, services or solutions"-- and Savvis, which offers infrastructure as a service to customers such as NYSE and MarketAxess.

How hardware and IT services are affected
The SaaS market is expected to grow to more than $10 billion over the next two years -- a fraction of the global business software market of $200 billion -- but it accelerates some industry trends.

The first 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; coupled with the steady maintenance revenues, this 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, it may contribute to harder times for hardware sellers that don't shift themselves to an on-demand model. Companies do not need a lot of gear with SaaS: a web browser and broadband connection are the entire IT infrastructure needed. On the other hand, SaaS companies need others to manage their infrastructure -- data center, servers, storage, and middleware -- and service delivery platforms.

Third, the traditional model of selling enterprise software -- IT services firms serve as a sales channel, in return for a consulting engagement to implement the software -- will suffer. Companies like IBM (NYSE:IBM) are responding by stressing industry expertise and their ability to deliver client results.

Room to grow
The base case for investing in SaaS companies is the ability to access a new growth opportunity -- the millions of small- and mid-sized companies in the world who could not afford, or were afraid of the risks of, enterprise-class software. As IT industrializes and standardizes, the opportunity to extend to large companies will also ripen. The SaaS model can apply to a range of functions beyond customer relationship management, and it offers some of the most exciting investment opportunities available -- but only for the daring.

Meanwhile, it's back to the tank for Mr. Blaine.

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Fool contributor John Finneran is a consultant, investment analyst, and writer specializing in the financial value of technology. He does not own any of the shares mentioned. Feel free to email him with comments and feedback.