Burnham's Beat

Software's Top 10 2005 Trends: #3 Software As A Service

Software as a service has a bit of a bad reputation thanks largely to the Application Service Provider (ASP) debacle of the mid-1990s.  Back then, a huge amount of money was poured into ASPs such as US Internetworking, Corio, and Interliant in the belief that companies would like to buy enterprise applications as hosted services

As it turned out, not many companies were interested in buying mission critical software as a hosted service. Not only did hosted apps have significant security and performance issues, but they were difficult to customize and integrate into an enterprise’s other systems. On top of this, the economics of providing enterprise software as a service were terrible. ASPs were required to make huge upfront investments in hardware and software but they only got paid a monthly subscription (which could often be cancelled with little notice).  In addition, competition from other venture funded startups drove pricing down and drove customer churn and factor costs (such as hosting and bandwidth charges) up.  This turned out to be a recipe for disaster and many ASP’s ultimately ended up going bankrupt under crushing debt loads.

Fast forward to 2005 and things are now actually quite different.  First off, the main costs required to offer software as a service have declined dramatically.  As Ryan McIntyre outlines in his excellent post on data center economics, datacenter/hosting costs have plummeted in the last 10 years with bandwidth costs declining 88%, storage costs declining an amazing 99.7% and CPU costs declining an even more amazing 99.9%!  (When you think about this from a business economics standpoint it really is stunning.)  With lower costs, the upfront investment required to offer software as a service is actually now quite reasonable.

Outside of lower costs, three other developments have helped make software a service much more attractive.  First, developers have created new applications that have been engineered from the ground up to be offered as a hosted service and even many existing applications have been re-engineered to make them more “hosting-friendly”.  Second, the advent of XML and web services has made it easier for companies to integrate hosted applications and data into their own legacy systems.  From a technical perspective, this has removed one of the last major drawbacks of hosted software.  And finally, 10 years of exposure to the web has made many corporate managers much more comfortable with the idea of hosted-applications.  Even many IT managers, who at first resisted hosted applications as a potential threat to their jobs and influence have now warmed up to hosted-apps as a way to quickly meet business unit needs without adding significant costs to their own organization.  For many developers, selling a hosted software solution is now an easier and faster process than selling installable code.

On the strength of these developments, 2005 may very well turn out to be the year that software as a service goes from being an alternative means of delivering software to being the preferred means.

For VCs, the growing acceptance of software as a service combined with its improved economics raises the possibility that it is very risky, if not downright ill-advised, to fund any new enterprise application that is not designed primarily to be offered as a service.  It also raises the prospect that new applications architected from the ground up to be offered as a service may be able to displace well established client-server players in the ERP, database, and vertical application space much as those players did to mainframe and mini-computer vendors in 1980’s and 1990’s.  Indeed some categories of applications, such as inter-enterprise applications, are not even possible unless offered as a service.   All of this adds up to make enterprise applications a much more interesting investment space than it was just a few years ago.

For a complete list of Software's Top 10 2005 trends click here.

Honey I Bought The Wrong Company!

On Monday December 13^th Oracle announced that it had finally reached an agreement to acquire Peoplesoft thus ending a corporate siege reminiscent of the Roman siege of the Masada. While I suspect many at Oracle are feeling quite triumphant right now, they have a big problem: they brought the wrong company.

The Other Deal

Just two days after the Peoplesoft deal was announced, Symantec announced that it was going to buy Veritas for $13.5BN. Veritas is the market leader in backup, recovery, and high availability software and also an emerging player in the database and application management markets thanks to its acquisition of Precise in 2002. As it happens, Veritas built much of its business by selling back-up and recovery software to Oracle’s customers (much in the same way that Business Objects built its BI business).

As I have written before, Oracle’s pursuit of Peoplesoft appears to have been based on two main assumptions: 1) Oracle can generate significant scale economies and marginally increase its overall growth rate by acquiring one of its major ERP competitors. 2) Oracle’s belief that its core market, data management, is a mature, low growth space.

It’s hard to dispute assumption #1 (although with the higher price Oracle is paying the deal is inherently less accretive), however assumption #2 is likely flat out wrong. There is a relative explosion of growth and innovation going on the data management business compared to the ERP business. Whether it's unstructured data management, application management, virtualization, or disaster recovery, new opportunities for growth abound in the data management space.

Just look at Veritas. It has made data management (in a broad sense) its core business and has grown revenues 17% between 2001 and 2003 while Peoplesoft has only grown its revenues only 9.4% during the same period. Granted, Veritas isn’t exactly a growth poster child, but it would have grown much faster if it wasn’t for some sales execution and product transition issues (thus its sellout to Symantec).

Moving the Needle … In the Wrong Direction

After I wrote my last piece on Oracle, a few people who claimed to be in the know told me “Hey, Oracle knows that data management represents an attractive long term opportunity, but Oracle needs to make acquisitions that will move the needle in the short term, and there are no comparable companies in the data management space that are big enough to make a difference”.

Unfortunately that statement doesn’t hold much water when one looks at Veritas. While Peoplesoft does indeed have more revenues with $699M vs. Veritas’ $497M in Q3 04 revenues, 77% of that revenue came from low margin services revenue vs. Veritas’ 42%. Given its huge services business, it's not surprising that Peoplesoft is much less profitable than Veritas with only $40M in operating profits vs. Veritas’ $96M in Q3 04. On a trailing 12 month basis this profit differential is even worse with Peoplesoft earning only $107M in profits vs. Veritas’ $500M.

What this means is that Oracle’s $10.3BN acquisition of Peoplesoft, excluding cash, equates to about 81X times operating income while Symantec is getting Veritas for the comparative bargain of about 22X operating income. Even if Oracle can get PSFT’s operating earnings back up to $250M/year (where they were in 2002 … and 2001) that’s still 35X operating income.

When you net it all out, from even an optimistic perspective, Oracle looks to be paying about a 50%+ premium for a business that is growing about ½ the rate of Veritas and producing far less in absolute dollar profits.

Whoops!

It’s hard to look at these numbers as well as the relative long term growth opportunities in ERP vs. data management and not come to the conclusion that Oracle is truly buying the wrong company. The irony of the situation is probably not lost on Oracle’s former product head, Gary Bloom, who just happens to be CEO of Veritas. I can just imagine him sitting back in his chair, shaking his head, and laughing.