The Changing Software Business

Presentation for OECD-METI-RIETI ConferenceOctober 6-7, 2008

Michael A. CusumanoMIT Sloan School of Management

cusumano@mit.edu© 2008

2

Software Products Business• Decline of New Enterprise Sales (or Prices)

– Only exceptions are hits & “platform” products?• Growth of Services & Maintenance Sales

– Technology glut from Internet boom and Y2K– Freeware and open source driving some prices to zero– Customers rebel against costly commodity products

• Emergence of New Business & Pricing ModelsSoftware as a Service– cheaper products, bundled

support & maintenance (e.g. Salesforce.com) Free, But Not Free, Again – software supported by

advertising (e.g. Google, Yahoo, Windows Live)

3

Siebel

0102030405060708090

100

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

% o

f Tot

al R

even

ues

NewProdServMain

Siebel

0

200

400

600

800

1000

1200

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

$ million

NewProd

ServMain

4

Oracle

0

10

20

30

40

50

60

70

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

% o

f Tot

al R

even

ues

NewProd

ServMain

Oracle

02000400060008000

1000012000

1992

1994

1996

1998

2000

2002

2004

2006

$ million

New Prod

ServMain

5 7

Business or Life Cycle Models?

0102030405060708090

Produc

ts

Hybrid

Solu

tions

Service

s

% o

f Tot

al R

even

ues

ProductsServices

Source: M. Cusumano, The Business of Software (2004)

99% of 0 = 0? Margins too low?

5

6

Public Software Product FirmsListed on US Stock Exchanges (SIC 7372)

050

100

150

200

250

300

350

400

(mea

n) d

ensity

all

1990 1992 1994 1996 1998 2000 2002 2004 2006fyadj

Number of Firms in the Industry - All Sample

7Source: Andreas Goeldi survey (MIT master’s thesis, 2007) n=108

Web-Based Enterprise Software VendorsYear of Company Formation

0

5

10

15

20

25

1911

1972

1975

1977

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Year

.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

Frequency

Cumulative %

8

New Business Model DimensionsRevenue Model

Customers

Delivery Model

Local ClientInstallation

Local ServerInstallation

RemoteWeb-based

Remoteproprietary(e.g. hostedSAP)

Up-frontlicense fee

Subscription/Software as aservice

Advertisting-based

Transaction-based

Free but notfree (bundled)

Free (revenuesfrom services

Bundled aspart of a hardware product

Mainstream consumers

Early-adopter consumers

Small businesses

Mainstream enterprise customers

Early-adopter enterprise cust.

Source: 2006 MIT student team Krishna Boppana, Andreas Göldi, Bettina Hein, Paul Hsu, Tim Jones (Cusumano, The Software Business, 15.358)

Traditional

9

0

20

40

60

80

100

Frequencyn=180

Business Models

108 Web-Based Enterprise Software Vendors

Monthly Fee

Free

Upfront License Fee

Professional Services

Open Source

Advertising

Pay Per Use

89

29 30

6 216

Source: Andreas Goeldi survey (MIT master’s thesis, 2007)

7

Traditional

10

Different Evolution Curve –Product, Process, and/then Services?

Focus ofAttention,Revenues

Time

Product Innovation Process InnovationService Innovation

Source: Adapted from Utterback and Abernathy

Different S-Curve Dynamics –Product Platform Disruptions Generate New

Services & New Business Models?

Performance

Time

Ferment

Takeoff

Maturity

Platform Disruption

New Services?New Biz Models?

12

Rise in services and new business models temporary

Strategy Questions

or permanent?

• Temporary Argument: In transition phase between platform and business model innovations (now client-server to internet to web services)

• Permanent Argument: Software now commoditized and prices will fall close to zero for standard products. Future is software as a service or “free but not free,”supported by advertising or other indirect revenues. Many other technology-based global industries will follow – such as consumer electronics & automobiles?

13

Software Products Company Database Study

• Research project with Prof. Fernando Suarez (Boston U.) and Steve Kahl (Chicago GSB)

• Identified ca. 500 public software “products firms”(listed on US stock exchanges) under SIC code 7372 –PrePackaged Software

• Since 2003, downloaded data from Compustat, Mergent, and directly from 10K reports

• Over 3000 yearly usable observations• Average 10+ years of detailed financial data from 1990

or later

14

.2.3

.4.5

.6.7

.8

1990 1992 1994 1996 1998 2000 2002 2004 2006fyadj

(mean) servpctsales (mean) prodpctsales

Service vs Product as % Sales - Average All Sample

Note: Services including maintenance (about 55% of services revenues for firms breaking this out)

excluding video games

15

including video games

414045

81

91

121

109101

121

145137140

154154145

138144

135133132

120115

108

64

77

58

45 42

3224

1817 20

63

0.1.2.3.4.5.6.7.8.91Fr

eque

ncy

0 .2 .4 .6 .8 1servpctsales

Histogram of Service as % of Sales - All Sample 1990-2006

100% product 100% service

17 17

Service/Maintenance vs. Product Revenues

18 18

Service/Maintenance vs. Product Revenues

19 19

Service/Maintenance vs. Product Revenues

20

21

.2.3

.4.5

.6.7

.8A

vera

ge P

ct S

ervi

ces

over

Sal

es

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36Age of the Firm

Service Percent of Sales vs. Firm Age - All Sample

22

Services as % of total sales rise as…• Firms age (services rise 1.8%/yr)• Product sales growth slows down• Industry consolidates (maturity, price

competition)• Industry recession (2001-2003 – prices fall)• Internet products (disruption?) introduced

though firm effects – age, product growth lag, total sales lag – most important effect

Why do Most Software Product Companies Shift to Services?

(Regression Analysis)

23

Grow

th index

Time

Services

Products

Grow

th index

Time

Services

Products

A: Case of a firm where products and services revenues reinforce each other

B: Case of a firm where products and services revenues do not reinforce each other

24

Some More Data Analysis• Services have positive impact on operating profits of

product companies when reach about 60% of total sales– About 70% product sales optimal for profitability

• Hybrid firms generally have (1) higher and more stable profits and (2) higher market valuations than the average “pure” (100%) software product firm– But pure product firms disappearing in software industry

• Maintenance about 55-60% of service revenues, for software product companies, with high gross margins– Each 10% increase in maintenance as a % of service &

maintenance revenues = 5% increase in SM gross margins

25 7

Services Impact on Profits & Market Value: Sweet (vs. Sour) Spots

0102030405060708090

Produc

ts

Hybrid

Solu

tions

Service

s

% o

f Tot

al R

even

ues

ProductsServices

SweetSpot?

Stuckin the

Middle?

Scale/Scope Economies Begin?

20% 60%

Sample: Software Product Companies25

26

Impact of Industry Change on SI and IT Services Firms?

• Client server to internet led to major increase in public IT services firms in US

• But consolidation of industry and products business also seen in IT services firms– Number of publicly listed firms in our database dropped from ca. 550 in

2000 to under 400 in 2005 (preliminary estimate, multiple SIC codes)– Product sales used to be 20% of service firms’ revenues; sharp decline to

3% today (estimate)

• Software product and other technology companies could have taken more of the services business for themselves – and probably will in future!

27

Public IT Services FirmsListed on US Stock Exchanges

0

100

200

300

400

500

60019

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

04

Num

ber o

f firm

s

APAC(***) firmsEMEA(**) firmsNA(*) firms

* North-America including Caiman islands and Bermuda. ** Europe and Middle-Eastern. *** Asia-Pacific

(SIC codes 7370, 7371, 7373 for computer services, and mgt consulting IT services 8742)

28

Revenue Mix in IT Services Firms

0

20

40

60

80

100

12019

90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

$ Bi

llion Services

Products

29

Services % of Sales at Select Hardware Firms

0

10

20

30

40

50

6019

9619

9719

9819

9920

0020

0120

0220

0320

0420

05

% S

ales

IBMHPSun MicrosystemsEMCCiscoDell

Conclusions• Pure software product firms are disappearing, except

some platform leaders or hit product companies• “Pure” IT services firms also disappearing, and under

threat from low-cost-good quality services in India, etc. • IT services firms, former partners of the product firms,

now must compete for the same services revenues!• But services remain essential to de-commoditize product

technology and add new sources of revenues & profits: Hybrid Business Model

– Products remain the “engine” that drives new service and maintenance revenues

– All firms must develop stronger services capabilities30

31

Impact of Industry Change on IT Services Firms?

• Client server to internet led to major increase in public IT services firms in US

• But consolidation of industry and products business also seen in IT services firms– Number of publicly listed firms dropped from ca. 500 in 1999 to ca. 250

in 2006 (preliminary estimate, multiple SIC codes)– Product sales used to be 20% of service firms’ revenues; sharp decline to

3% today (estimate)

• THE BATTLE: Software product companies now fighting with current/former partners (IT and SI services companies) for the same services revenue!