Software as a Service

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Software is ubiquitous in today’s business world, where software applications can help us track shipments across multiple countries, manage large inventories, train employees, and even help us form good working relationships with customers. For decades, companies have run software on their own internal infrastructures or computer networks. In recent years, traditional software license purchases have begun to seem antiquated, as many vendors and customers have migrated to a software as a service business model. Software as a service, or 'SaaS', is a software application delivery model by which an enterprise vendor develops a web-based software application, and then hosts and operates that application over the Internet for use by its customers. Customers do not need to buy software licenses or additional infrastructure equipment, and typically only pay monthly fees (also referred to as annuity payments) for using the software. It is important to note that SaaS typically encapsulates enterprise as opposed to consumer-oriented web-hosted software, which is generally known as web 2.0. According to a leading research firm, the SaaS market reached $6.3B in 2006; still a small fraction of the over $300B licensed software industry. However, growth in SaaS since 2000 has averaged 26% CAGR, while licensed software growth has remained relatively flat. Demand for SaaS is being driven by real business needs — namely its ability to drive down IT-related costs, decrease deployment times, and foster innovation.


As SaaS adoption continues to accelerate, traditional software application vendors or ISV’s could face fierce competition from SaaS upstarts looking to steal market share. Over time, they could see their existing customers defect, and prospective new customers balk at their product delivery options (or lack thereof) – resulting in lower revenues, operating margins, and profits. Alternatively, ISV's could adopt SaaS models -- hence risking the cannibalization of their own software license revenue. Consequently, the disruption of ISV’s offerings would hurt the demand for technology software service/consulting firms, who earn profits by integrating, customizing, maintaining, and upgrading traditional licensed software. On the other hand, pure play SaaS software companies, third - party application hosts, and Internet technology providers all stand to gain with accelerated SaaS adoption.

Kinds of SaaS

Business Applications

The Business Applications industry represents software that helps various businesses accomplish their tasks quickly and accurately. Magic Formula stocks in this industry include global leaders such as Microsoft (MSFT), Accenture (ACN), and Electronic Data Systems (EDS), as well as smaller niche players like STARLIMS Technologies (LIMS) and American Software (AMSWA). This is a pretty broad range of providers. Microsoft, of course, makes the ubiquitous Windows operating system and Office productivity software that is used by the vast majority of businesses today. Compare this broad based offering to STARLIMS, which focuses on a very specific niche - laboratory data management.

Business Applications as a sector is difficult to merit. The best opportunities here are either those companies with a large installed base or a very specific niche. For example, American Software produces Enterprise Resource Planning (ERP) software, a way for clients to track their resources and allocate them efficiently. However, this market is controlled by software giant SAP AG (SAP), who has much larger financial resources, name recognition, and client base. For the companies with a large installed base, like Microsoft, switching costs are high because it would require a lot of time and money to re-train employees to use a new system. Additionally, since everyone knows Microsoft tools, the network effect is in place, making adoption of Microsoft's software necessary for smooth sharing of information across business segments or with customers.

Development Tools

Another broad based industry, Development Tools consist of software that is used primarily for product development and management, as opposed to business process management. Companies in this industry are usually focused towards one type of product. Stocks here include Cadence Design Systems (CDNS), a provider of semiconductor design tools, and Logility (LGTY), which provides inventory management systems.

what the hell is this?

In truth, the line between Development Tools and Business Applications is not well defined to me. A stock like Autodesk (ADSK) is classified by many as a Business Applications company, but in truth it's AutoCAD software is used in product development. On the other hand, Adobe Systems (ADBE) is correctly identified as a Development Tools company. In any case, Development Tools is a less attractive sub-sector. Here, technology can wipe out any competitive advantages. New methods or advances in product design can lead to quicker development times, cheaper production costs, etc. As in Business Applications, the best way to build a lasting competitive advantage is to become an industry standard. Take Adobe for example. Although there exist many Photoshop clones, some free and almost all cheaper, there is little risk to Adobe. Graphics professionals are trained to use Photoshop in school, are comfortable with it, and do not want to take the time to learn something else unless it provides a very great advantage.

What is driving SaaS adoption?

The software market has matured from its days of double-digit growth back in the era of the Internet bubble to presently growing in the mid - to high single digits. This general industry maturing, the trend of outsourcing, as well as the mitigation of security and operational control risks, have all contributed to the accelerated adoption of SaaS delivery models.

Description
Description

Maturing Software Industry/ Maturing Corporate Customers

The hyper-growth of the past, driven by cutting edge applications and the scarcity of solutions to improve productivity, seems to be largely behind us. Today, corporate buyers often have the ability to choose among a myriad of comparable software solutions–including lower cost SaaS solutions. SaaS not only alleviates the costs of traditional perpetual licensing fees but also eliminates the need for additional IT infrastructure investments to support new applications. In addition to fewer up-front costs, SaaS is often easier to discontinue or substitute, reducing switching costs. Nowadays, many buyers are applying the same fundamentals to technology purchases as they have been to other acquisitions – focusing on total cost of ownership (TCO) and return on investment (ROI). While comparing traditional CRM software packages, a recent study from the Software & Information Industry Association (SIIA) found that the TCO of the Salesforce.com CRM SaaS offering was 10 - 20% of the TCO of traditional CRM. The consensus seems to be that SaaS could lead to a potentially weaker bargaining position for sellers of traditional software products, and a stronger position for SaaS solution providers.

Description
Description

IT Outsourcing Trend

SaaS is a version of business process outsourcing (BPO) since it delivers software functionality without the overhead of operating the application. Outsourcing has become an increasingly important enterprise strategy, given that the IT outsourcing industry has grown at an average rate of 7.3% CAGR since 2003. Whether offshore or onshore, if companies are comfortable outsourcing key business functions and processes, then why not the operation of their software applications as well?

Mitigation of Security and Operational Risk

SaaS has long been considered a potential security and operational risk because it often requires that proprietary company data be transported outside of the confines of the internal network. However, the recent availability of better remote security technologies and data redundancy tools, together with the five nines availability of many SaaS vendors, may prove SaaS to be less risky.

Who Stands to Gain?

Salesforce.com and RightNow Technologies (RNOW), both leading pure play SaaS solution providers, are in the best position to directly gain from adoption. The new delivery model has given them the opportunity to effectively compete with entrenched industry giants. Additionally, the predictability of their cash flows resulting from an annuity model make them appealing to many investors. SaaS has already influenced software sectors such as customer relationship management (CRM), supply chain management (SCM), web conferencing, human resource management (HRM), financial management, and E-commerce/email; look for it to invade other established sectors such as enterprise resource management (ERP), project life cycle management (PLM), computer security, and collaboration software in the future.

Electronic Data Systems (EDS),Equinix (EQIX), and SAVVIS (SVVS), all leading third-party network hosting companies, stand to benefit if they decide to take advantage of the transition to SaaS models by paying ample attention to SaaS application developers and their needs and adding SaaS software providers as customers. Furthermore, those hosts that support the trend could have a commanding lead over their late adopting competitors in this arena. It is important to note that EDS also provides IT/Software consulting services (see Who Stands to Lose).

Akamai Technologies (AKAM) and VeriSign (VRSN), two leading Internet technology providers who benefit from increased Internet usage, stand to gain as more enterprises access their applications via the internet using SaaS. Akamai offers a Web application acceleration solution that enables SaaS providers to deliver services to any enterprise regardless of size and geographic distribution, and VeriSign provides SaaS security-related web technologies such as hosted email security and filtering.

Google (GOOG) announced the $625 million acquisition of Postini, a provider of corporate security and anti-spam services. The search advertising giant may leverage this acquisition as part of their overall online applications offering, which includes email, chat, documents and spreadsheets, among others.

The evolution of SaaS effectively lowers barriers to entry in the software space as well. SaaS-type sales can occur further down the management chain than legacy, full-scale, enterprise-class business, which is geared to C-level decision makers. This enables organizations without large sales organizations to make effective in-roads at the grass roots level by appealing to programmers/developers. An example of a company that is building such a strategy is Actuate (ACTU), which is focusing on an open-source platform as they compete in the Business Intelligence space.

Who Stands to Lose?

Microsoft (MSFT) and Oracle (ORCL), traditional ISV giants, as well as Cognos (COGN) and Intuit (INTU), two examples of traditional ISV niche players, have the most to lose as SaaS vendors position themselves to steal market share. Vendors who ignore SaaS could be at a competitive disadvantage long-term if the trend continues, while vendors who adopt SaaS early may be in a stronger competitive position. Larger ISV's adopting SaaS could face challenges because of the changes in network architectures (often but not always using service-oriented architectures or SOA) required to successfully exploit SaaS opportunities. Also, it is important to reiterate the risk of these traditional ISV's cannibalizing existing licensed revenues. Most industry analysts agree that it is unlikely that SaaS will replace traditional software licenses. What is likely, however, is adoption of hybrid models where both traditional software and SaaS delivered software co-exist. It will be interesting to see which companies seamlessly make the transition to having a SaaS option and which do not.

Accenture (ACN), IBM Global Services, and Electronic Data Systems, leading software/IT consulting companies, because they provide services to ensure that enterprise software works properly, stand to lose because these services are performed in-house by SaaS companies. With SaaS, clients may no longer need an Accenture (ACN) to show up with a large team of people for months at a time (sometimes years) to integrate, maintain, or customize enterprise software. Dis-intermediation is a risk for these consulting firms. It is important to note that IBM in particular has tried to embrace SaaS, aiming to substantially boost the number of SaaS software providers using IBM technology to host their SaaS offerings.

Dell (DELL) and Sun Microsystems (JAVA), leading examples of Network Infrastructure OEM's, may see reduced demand for their products because network resources are used more efficiently (often reused) in a SaaS driven SOA environment. Imagine a world in which individual companies aren't required to operate their software in house. They may spend less on servers and storage devices, among other equipment. Those equipment manufacturers who effectively develop hardware to support SaaS delivery may be able to mitigate their downside, while others could find themselves struggling to compete and losing market share.

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