FT : Salesforce Breaking New Ground

Monday, January 24, 2011

Stock market investors have finally been warming up to a software trend that has been more than 10 years in the making. That’s how it goes with big transitions in the underlying architecture of IT: there are many false dawns in what can appear to be inevitable long-term shifts – in this case, a new approach to information storage and processing, carried out remotely in large datacentres and delivered over the internet. The trick is not necessarily predicting what will happen next, but deciding which horse to back – and when to enter the race. So it has been with something that goes by the ungainly name of software-as-a-service (SaaS.) Like many tech trends, this one surfaced under a number of different guises – application service providers was one name given to the early players, on-demand software was another – before taking its current form. Is this finally its moment? The pioneer in this market, Salesforce.com , has seen its shares jump by 70 per cent in the past year. It sells an online service for salespeople to manage their customer data. At nearly $20bn, it is now worth more than software companies like Adobe, Symantec and Intuit – all of them much bigger and more profitable. Other SaaS names like NetSuite and SuccessFactors have been caught in the updraft.

Entrepreneurs and early investors usually blame accounting for the length of time it has taken Wall Street to get excited about SaaS. The argument goes like this: unlike traditional software companies, which book revenues upfront when they make a sale, these companies sell subscriptions – for instance, $50 a year per employee for a company that wants its sales staff to use an online application that manages their customer relationship data. Since those subscriptions often continue for years but all the costs of selling the service gets booked up front, SaaS companies can look unprofitable for many years, which makes investors cautious.  That argument is hard to swallow. Sure, Salesforce only just scrapes out a profit, but its operating cash flow jumped nearly two-thirds in the first nine months of 2010. It doesn’t take a maths genius to understand the economics of this business. A more likely explanation is the length of time it sometimes takes Wall Street to get comfortable with a new market and a new business model. Like all subscription businesses, SaaS companies live or die on a handful of key measures: the money they spend finding new customers, the amount they can extract from those customers in each accounting period, and the rate at which customers fail to renew their subscription agreements and have to be replaced with new ones (known as churn).

In a new market, it is not easy to tell how the dynamics of marketing costs, pricing and churn will settle down.  Salesforce, which has been at this game for 11 years, spent 47 per cent of its revenues on marketing costs in the latest nine months, a higher proportion than the year before. Does that mean it is ploughing everything into growth, or that it has to spend more on marketing because the business is getting more competitive? What happens to pricing when there is a thriving market of companies vying to outsource the handling of business processes like this? Another factor is the capital investment and operational risks involved in building what amounts to a utility business. Make no mistake, these companies aim to reach huge scale. ADP, the big, boring payroll processing company that has been around for half a century, is the darling that many in this industry look up to. Start-ups, which often lack patient long-term investors and struggle to control breakneck growth, may not seem the obvious entities to which large companies would want to entrust their key data and business processes. That caution points to the other, overriding reason why SaaS has taken time to emerge as a stock market investment story. The early market has been fuelled by small businesses that can not afford an IT department, along with departmental managers of large businesses who have enough autonomy to make decisions about how to handle non-core processes without involving the CIO. Getting to where the real money is – handling things like the financial processes and supply chains of big corporations – will take years. It’s all in the timing. Wall Street has finally decided that this is a business that’s here to stay – and that, in Salesforce, it has already thrown up at least one company that may emerge to stand alongside the big players in business software (if it isn’t bought by one of them along the way). But to live up to the new expectations they have created, it is time for the SaaS companies to prove that IT managers no longer fear the cloud.

Reference : The Financial Times, Jan 20th 2011.

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