The financial challenges of cloud pure plays: What they can learn from software vendors
Jillian Mirandi, Senior Analyst
JUL 07, 2014 01:19 AM
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TBR Assessment

There is little doubt that a fundamental change is happening in the way enterprises consume IT. Technological advancements that enable cloud deployments of enterprise software are driving the change. While the technology changes are notable, they also carry with them a business model change. Customers can now purchase IT in a more incremental and flexible way, changing the sales model from blue-suit selling to add-to-cart selling. The traditional approach to enterprise IT sales involves sending high-cost, direct account representatives (blue suits) to the client. This traditional process is long and involves developing technical requirements, publishing a request for proposals, replying with a proposal, negotiating contracts and finally deploying the product. With the development of cloud and the ability for customers to investigate capabilities themselves, customers can now identify what they need, shop around for the best cloud offerings and then purchase through a simple click of the "add to cart" button.

This fundamental shift in business and consumer IT purchase patterns is disrupting all aspects of the industry and forcing businesses to rationalize the labor requirements of their delivery models, igniting game-changing implications. As service delivery and ease of use increase in importance, they become the impetus for customers to continue and expand relationships with the vendor. Customer success teams, often outside of the sales organization, effectively become quotaless sales representatives, as customers who are receiving value from their services are the best targets for expansion. Additionally, this disruptive cycle calls for vendors to scrutinize all aspects of the sales and marketing (S&M) organization to find ways to improve efficiency. In many cases this will require organizations to rethink resource requirements.

Cloud Providers

TBR reviewed the financial reports from three leading publically traded cloud pure play vendors — Salesforce.com, ServiceNow and Workday — and compared them to some of the largest predominantly enterprise software vendors. From a selection perspective, TBR eliminated enterprise software vendors that also had large hardware or consumer businesses. Based on these criteria, we selected SAP, CA Technologies and Software AG to represent the traditional software vendors. We eliminated the vendors' professional services revenue and expenses, but did not eliminate the cloud offering from their financial statements. While cloud vendors did show slightly lower gross margin on average (see Figure 1), the difference was not significant enough to explain why cloud pure plays are not as profitable overall as the traditional vendors.

 

Despite the similar gross margins, a comparison of operating margins showed that the cloud providers are not profitable at this time (see Figure 2).

TBR believes that the reasons for this are as follows:

·        High S&M expenses to drive new business: Cloud vendors show considerably higher spending on S&M expense as a percentage of revenue than traditional software providers. The average spending on S&M for the three cloud providers that TBR studied was over 40% of their total revenues. This compares to approximately 30% for the traditional software vendors. This is due both to the land-grab that is happening in the cloud market, as well as the disproportionate way cloud revenue is recognized against S&M expense.

·        Importance of renewals: For traditional software vendors, there is less ongoing pressure to ensure that their services are renewed, primarily because the costs associated with migrating from one applications provider to another are considerable. In addition to the direct software costs, the consulting and systems integration services can, for some applications, be as high as six times the cost of the software. Finally, there is the investment and lost productivity that occurs as the workforce is trained on the new software. For cloud pure plays, these concerns, while still present, are reduced, thus increasing the pressure on ensuring that customers renew the services. Cloud vendors expect renewals to be low-cost and low-risk.

·        Importance of expansion: Along with new sales and renewals, expansion is the third pillar driving cloud revenue and sustainability. Many cloud vendors leverage the "land and expand" strategy of spending large amounts of time and money to enter new accounts, and then more easily expanding once customers find value. The customer success teams track usage and flag any issues to ensure customer satisfaction and drive upselling. For many vendors, expansion means the number of seats, but for more mature vendors, expansion equates to seats and additional paid-for services or support.

·        Automation: Ease of use is critical for cloud vendors to keep customers satisfied. Automation is a factor that increases ease of use by taking human involvement out of the process. Increasing automation is seen across cloud and traditional software vendors as customers want an easy-to-purchase, easy-to-deploy, and easy-to-use solution. For cloud vendors, increased automation will result in improved gross margins as the services delivery will require fewer resources.

These findings all point to the transition that cloud vendors are currently going through. The heart of this transition is the migration from startup to mature business. As a startup, the focus needs to be almost exclusively on top-line growth. This requires a focus on direct S&M. However, as these businesses mature, the focus eventually needs to shift to profitability, which we have not seen in TBR-covered cloud vendors, including 15-year-old Salesforce.com. This shift for the cloud pure plays involves driving a high renewal rate without dramatically increasing the S&M costs, and a revenue mix relying more on current customers over new customers. A greater reliance on the channel will also drive down high S&M, and investment in the ISV ecosystem will drive down R&D. We do not think this shift will happen over the next five years as the cloud market is growing so rapidly due to acceptance of the technology.

To effectively accomplish this shift, the cloud pure plays will need to determine the best ways to measure and incent both the S&M teams and the customer success and delivery teams. High-cost blue-suit sales staff will need to be focused on adding new logos, while the customer success and delivery teams need to be focused on ensuring that customers are receiving value form the services they have already purchased and are expanding those services. While this sounds straightforward, in many cases there are considerable cultural challenges associated with implementing incentive structures that attempt to accomplish this task. Specifically, in many organizations there is a premium placed on the acquisition of new logos at the expense of ensuring customer success. Within many organizations there is a perception, either justified or not, that the only way to advance is to be directly responsible for adding new logos or expanding share-of-wallet with existing customers. The teams responsible for ensuring customer satisfaction and continued renewals are seen as less critical for the overall business.

Managing this tension will be critical for the overall success of cloud pure plays. The blue-suit sales staff will need to be focused on net-new business and be discouraged from allocating time to what should become simple, low-cost renewal procedures. Once a company secures a new logo, its sales and delivery teams need to transfer responsibility for the success and expansion of the account to the customer success and delivery teams. Integral to this transition will be an electronic tracking system monitoring accounts throughout their life cycle — not simply as the renewal date approaches — and triggering automated touch points to pulse check accounts and flag those in danger of not being renewed. These tools will ensure organizations can coordinate a focused response to problems using sales, marketing and delivery. These steps should result in lucrative renewals and much lower selling expenses.

From a services delivery perspective, advances in technology will further automate the process. Specifically, underlying analytics will have to take more labor out of the services delivery process. Cloud providers will need to constantly manage their delivery growth to ensure they have sufficient personnel to manage their customer and offerings growth, while also investing in R&D and service automation at the right level to ensure they are not building a model that cannot lead to profitability due to excessive staffing costs.

Company examples

In evaluating these three companies' 10K forms, TBR investigated the standard metrics for three cloud-based providers.

Salesforce.com

Salesforce.com changed software pricing over a decade ago and is arguably the missionary market maker. The company has sustained a high 30% growth rate year-to-year and will generate an estimated $1.2 billion in revenue in CY1Q14. While Salesforce.com is likely the largest CRM vendor globally and has impressive brand recognition, it continues to operate at a loss due to high S&M expenses. TBR does not discredit Salesforce.com's achievements because they operate at a loss, as we believe they could dramatically cut S&M and continue to grow, albeit at a slower pace. Salesforce.com is betting on the high rate of market expansion and opportunity over profitability, and they are making the right choice to focus on growth over profit for the time being. Salesforce.com is an applications vendor that is beginning to more tightly integrate and bundle applications and move into a platform play. Figure 3 shows Salesforce.com's spending as a percentage of revenue compared to selected other traditional software vendors and cloud providers.

 

This shows that in general the cloud providers are spending considerably more of their revenue on S&M expenses.

Workday

Workday extends the Salesforce.com model over from CRM into HCM and more recently, financial management. The company offers slightly more customization services than Salesforce.com and arguably has come to market with a "Salesforce Lite" business model. Over the past year, Workday has spent a considerable portion of its revenue on R&D. Figure 4 shows Workday's spending compared to the other vendors studied. The data show Workday spends considerably more on R&D as a percentage of total revenue compared to other firms in the study. TBR believes that this is due to Workday's current aggressive portfolio expansion strategy. The goal of the expansion is to both drive top-line revenue growth and to increase share-of-wallet and stickiness inside its customer base. From what TBR has seen in the cloud market, the ability to cross-sell and upsell customers is a key indicator of customer satisfaction. Further, the applications market tends to require high levels of initial investment to develop not only the applications, but the vertical modules for them.

 

 

ServiceNow

Finally, ServiceNow is the furthest along of the three when it comes to being a platform play, providing customers with considerable customizations for tailoring base technologies to their specific needs. It lends itself to attracting ISV development, extending the stickiness through horizontal and vertically focused applications cropping up between vendor and customer as cloud provisioning accelerates. TBR did not notice any one metric that significantly differentiated ServiceNow from its competitors. However, the combination of slightly lower gross margins, higher S&M and in-line R&D expenses produces improved operating margins compared to Workday, which has similar top-line revenue. Where ServiceNow does differentiate from many of its pure-play cloud competitors is in its shift from the co-location data center model to building its own mirrored data centers, thus incurring significant costs.

The future of cloud providers

For cloud pure plays to achieve profitability TBR believes they will need to focus on the following strategies:

·        Ensure high renewal rates: The high percentage of revenue that cloud providers are currently spending on S&M will need to decline. While a business model is new, and companies are immature, the increased spending on S&M is required as they attempt to build brand awareness and a reliable customer base. In a traditional software business this high spending can be easily recouped over the long life cycle of the install base through the ongoing maintenance model. However, in the cloud market this may not be the case. One of the attractions of the cloud is the ability to avoid vendor lock-in. As a result cloud deployments tend to be associated with shorter contracts on average, typically two to three years for applications and a much shorter time frame for infrastructure, compared to the seven- to 10-year install base for traditional on-premises application software. Because of this the ability to recoup the initial expense is dependent on achieving a very high renewal rate. With a high renewal rate, cloud vendors can either focus high-cost direct sales forces on the acquisition of new customers, or shift the mix and reduce the overall S&M expense as a percentage of revenue.

·        Automate the services delivery: In addition to reducing S&M expenses, TBR believes that publically traded cloud pure plays need to improve overall gross margins. This will involve aggressively automating the services delivery. TBR believes that given the nature of the cloud market, it will be more challenging for cloud providers to consistently achieve margins similar to those of traditional software providers. However, this does not mean that improvements cannot be made through automation of services delivery.

·        Build out the portfolio through an ecosystem-led approach: While R&D remains critical to integrating and continually improving cloud offerings, the cloud vendor with the broadest and deepest ecosystem will ultimately win. With the majority of cloud vendors vying to be the platform-based backbone of their customers, an ecosystem of ISVs and System Integrators (SIs) will drive vertical and horizontal portfolio expansion, as well as provide the consulting and integration cloud vendors may not have the experience or capacity to take on.

In some cases these actions may prove difficult to undertake. The rationalization of the mix of S&M resources may prove particularly difficult, as in many cases organizations have become reliant on higher-cost direct sales staff. However, as the organizations age, the need to rationalize these expenses will become increasingly pressing and will require difficult decisions. TBR expects companies will be tempted to first try to cut costs by reducing services delivery capabilities or R&D in automation of services delivery. In many cases this may be done in an effort to reduce expenses without altering the sales channel mix. TBR does not think this strategy will be profitable over the longer term, as services automation will be critical and delaying the rationalization of sales resources will only make that decision more difficult as time passes. 

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