What Wall Street Does Not Understand About SaaS

ByShaun Snapp

Executive Summary

  • Wall Street continually pushes companies to be Cloud, but without understanding how cloud revenues work.
  • We cover what Wall Street is missing in their analysis.

Introduction

This article will cover Wall Street’s perspective on SaaS and what the real story is with the shift in the commercial software market.

What Wall Street Interprets of SaaS and How They Are Pushing Vendors to Become SaaS

At some point, Wall Street collectively decided (and it does appear to be collective.

This is why calls like the Q1 analyst call covered in the article How SAP’s Mislead Analysts on the Q1 2017 Earnings Call, illustrated how SAP intended to present itself as having moved far more quickly to the Cloud than it actually had. The reason for this is simple. Wall Street provides higher recommendations for more SaaS / Cloud software vendors than vendors that show more of their revenues being based on on-premises sales.

Wall Street most likely takes this view because they have difficulty differentiating between a pure SaaS vendor like Salesforce, AWS, and Arena Solutions, versus a vendor like SAP or Oracle that “cloud wash” their offerings. Larry Ellison essentially admitted to performing cloud washing in the following quotation:

“The interesting thing about Cloud computing is that we’ve redefined Cloud computing to include everything that we already do.” And… “We’ll make Cloud computing announcements because, you know, if orange is the new pink, we’ll make orange blouses. I mean, I’m not gonna fight this thing … well, maybe we’ll do an ad. Uh, I don’t understand what we would do differently in the light of Cloud computing, other than market … you know, change the wording on some of our ads.”

Larry’s statement here is false. There is plenty that Oracle does that has nothing to do with the Cloud. In fact, most of the Oracle software that is used is used by companies on-premises.

Secondly, Oracle does not follow any of the rules of a pure SaaS vendor.

  1. One obvious item is that Oracle contracts are not terminable every month.
  2. Oracle also does not have published pricing.

Finally, if Oracle were indeed so Cloud in orientation, they would not have to perform as many horrific software audits that they do. Pure SaaS vendors already know their customer’s usage of the software. This is because of the customer’s users login to the vendor’s server.

Why Wall Street Loves SaaS

Wall Street is, in part, attracted to the re-accruing revenue of SaaS vendors and the implied economies of scale that pure SaaS vendors have been able to attain, one of the most prominent parts of this being multi-tenant databases. The original SaaS concept had significant advantages, such as the following:

  1. One Code Base: This makes upgrades easy and allows for incremental rather than major upgrade events. This reduces upgrade costs.
  2. Multi-Tenant Database: Allows multiple customers to be placed in a single database, drastically reducing database overhead.
  3. Vendor Provided Hosting and Maintenance: And for an application in which they specialize. This is unlike a customer’s IT department that must maintain many different systems.
  4. No Customization: Positive in that it cuts down on implementation cost and timeline.
  5. Flexible Cancellation: Good for the customer, not for the vendor.
  6. Published and Transparent Pricing: Good for market efficiency.
  7. Lower Sales Acquisition Costs: Which can be passed on to the customer.
  8. The Use of Self-Guided Demo Systems: Reducing sales acquisition costs.

Recently the concept has been modified by the following:

  1. The difference between theoretical and real benefits: The benefits received from SaaS are often when the SaaS offering is in a perfect state. Many realities reduce the actual benefits of SaaS.
  2. Vendors that do not have a SaaS heritage overstating their “SaaSiness”: Many software vendors are forced to at least speak in SaaS terms to appeal to investors. Software vendors want to be perceived as SaaS/Cloud vendors, although the world’s largest software vendors are not primarily SaaS-based. They offer some SaaS applications but still derive most of their revenues mainly from on-premises applications. Some of the largest enterprise software vendors, with substantial media footprints, also have an incentive to blur the line as much as possible between SaaS/cloud versus on-premises.

The reason these companies want to appear as SaaS as possible is simple. The executives at the major software companies may make around 2/3rds of their total compensation from stock options. Several top executives for major software vendors make between $100 million and $150 million per year.

The Problem with Wall Street’s Interpretation

Wall Street does not seem to understand that the on-premises software model provided barriers to entry, lock-in and made the overall enterprise software market less efficient. And with less efficiency comes higher prices. If one looks at the largest 23 software vendors by revenue, which you can at the article The World’s 23 Largest Software Vendors, what becomes apparent that only Salesforce and Adobe are SaaS vendors that are in the top 23. (AWS should be in the top 23 but is not classified as a software vendor as they do not (by in large and except for offerings like Amazon Aurora) produce their software. Salesforce has never been a profitable company. They are supported by the expected future value of those that buy Salesforce stock.

Salesforce has never been a profitable company. They are supported by the expected future value of those that buy Salesforce stock. Adobe is a profitable company. Several years ago, they transitioned from an entirely on-premises model to a SaaS model and should be considered the most successful vendor to do this. So it is possible, but a single company does not a trend make. Secondly, unlike Microsoft, Oracle, IBM, and SAP, Adobe’s business model was not based upon account control. Most of Adobe’s market is the consumer market, which does not work the same way as the corporate market. Therefore, software vendors that focus on the consumer market and that profitable transition to SaaS do not generalize to the enterprise software market. 

So who are the profitable companies at the top of the list? The top four are Microsoft, Oracle, IBM, and SAP. These are all historically on-premises software vendors that “dabble” in SaaS but still receive the predominant share of their income from on-premises sales.  As is covered in the article Will SQL Server Pass Oracle as the Most Popular Database?. Here are Oracle’s profits by area.

  1. Database Software: $1,445 Million
  2. On-Premises Applications: $1,022 Million
  3. Database Infrastructure: $250 Million
  4. Hardware Support: $125 Million
  5. Cloud Revenues: $83 Million

This is revenues, not profits.

As is pointed out by Stephen O’Grady (who I will cover in detail further in the article), if you were to reorder the top software vendors by market capitalization, it looks a lot different than the list when ranked by revenue.

  1. Apple
  2. Google
  3. Microsoft
  4. Samsung
  5. Verizon
  6. IBM
  7. Oracle
  8. Facebook
  9. AT&T
  10. Amazon

Notice the bolded vendors because I will come back to them in a moment.

What Wall Street Is Missing

In the book The Software Paradox: The Rise and Fall of the Commerical Software Market, Stephen O’Grady persuasively argues that the software industry is going through a sea change. A similar sea change occurred when hardware was charged for components and software was given away for free. O’Grady argues and presents evidence that the major on-premises software vendors are showing declining profitability. The lack of revenue reduction is confusing analysts as to the nature of the shift that is occurring.

Furthermore, the companies that have really grown in the past ten years have made money, not from software, but from charging for something else related to that software. Notable examples of this are the following:

  1. Apple: Has stopped charging for much of its software (the Mac OS, the IOS, Keynote, Pages, etc..). But uses its software to sell high margin hardware (i.e., the old IBM model)
  2. Google: Makes its money almost entirely from ads but uses its software to gain the world’s largest audience to serve those ads.
  3. AWS: Creates close to no software but uses both software from proprietary vendors and the open-source community to “rent” access to the software. There is now no easier way to test different software than through AWS.
  4. Facebook: Trades access to its software in return for both advertising dollars and selling data about users to companies.
  5. Multiple Support Entities Based Upon Open Source: HortonWorks, Cloudera, MongoDB, and others are becoming extremely popular in NoSQL databases. They do not “make” software as much as they offer services around open-source software.

And here becomes the point where SaaS and no charging for software intertwine, which is where Wall Street gets it wrong.

AWS, as an example, is not so successful primarily because they are SaaS. Clearly, SaaS allows them to do what they do. However, AWS is successful (and profitable – posting $800 million on revenues of roughly $3.5 billion) because they do not charge for their software. That is, they don’t charge for software but software access.

What SaaS Leads To

SaaS is a compelling development in software right now. However, in the enterprise software market, at least (as opposed to the consumer software market), it does not seem likely to drive profitability. So far, it hasn’t. SaaS leads to higher efficiency, but it also leads to lower lock-in, more customer choice, less hidden costs (unlike on-premises, where many of the costs are allocated to consulting companies or the customer’s internal IT department.

All of these things lead to higher price sensitivity. We are coming out of a long-term bubble in software sales where various factors converged to lead to a state where most IT implementations most likely have a negative ROI. This is due to enterprise software parasitization, particularly on the part of the major monopoly software vendors (Oracle, IBM, SAP & Microsoft). And by the major IT consulting companies. This is covered in the article How Vendors and Consulting Firms parasitized enterprise Software’s ROI. One perfect example of this phenomenon is that ERP systems became the most widely implemented enterprise software, while as covered in the book The Real Story Behind ERP: Separating Fact from Fiction.

SaaS will lead to great things for customers, but it will not be a win for most software vendors. That is what Wall Street cares about (preferencing the producer over the consumer). It leads to higher market efficiency, and if there is one thing Wall Street will not tolerate, it is higher efficiency. Higher efficiency leads to lower profitability.

Wall Street is interested in investing in companies that can extract the most out of their customers, maximizing profits. 

For enterprise software, that time is now coming to a pass.

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Conclusion

Wall Street is missing a fundamental understanding of the software industry’s changes because they are overly focused on SaaS. The irony is that Wall Street will drive more vendors to become SaaS as soon as they possibly can. This is positive for software customers, but it will not lead to the outcome that Wall Street desires.

References

*https://www.cbronline.com/news/cloud/he-said-what-5-things-larry-ellison-actually-said-about-cloud-4563323

Stephen O’Grady, The Software Paradox, The Rise and Fall of the Commercial Software Market.

*https://nucleusresearch.com/research/single/business-critical-software-as-a-service-vendor-strategies/