SaaS economics, Part 2: price rises on the way?
- Summary:
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Large vendors are still not profitable
Comparing SAP and Salesforce makes for an interesting exercise
Prices look set to rise
The primary problem is that the public markets value growth above everything but achieving spectacular growth is not without the need for resources, principally in sales and marketing, As we saw in Part 1, those costs are extraordinarily high when measured against revenue. So let's turn to the big enterprise market. Here the picture is much the same as Skuk finds only on a grander scale.
When we look at the revenue growth rates of companies like Salesforce and their impressive forward projections, it is hard to see how you could not be pleased - at least with the top line revenue growth. But then I ran a comparison against SAP. The reason I did this was because Salesforce has the longest publicly quoted history of any SaaS apps vendor and so I could make like for like comparisons.
I cheated a bit by finding an end point where the companies were on roughly the same gross revenues. For Salesforce that would be now. For SAP it was 1992. I then took that year and worked backwards for as long as the public records allowed. You can see in the graph I created that while Salesforce appears to do well, SAP 'catches up' at the end. All of this was before the roaring 90's that saw SAP accelerate away from the pack, effectively destroying the incumbents it was competing against in 1992.
As you can see the results follow similar paths. In that sense and as something of an aside, the parallels become more interesting since many in the peanut gallery believe the SaaS providers will sweep the current incumbents aside. We shall see.
See below:
Of itself you might argue this is meaningless and to a point you'd be right except for one tiny problem that turns out to be critical in this kind of analysis. SAP was profitable. Salesforce isn't.
If we go back in time to do the same comparison with balance sheets, we find the following:
I took the two end point years (in SAP's case I had to use 1993 because I couldn't find 1992 and in Salesforce case, Q3 FY 2015 since that's the closest I could get to the numbers I needed) and then ran calculations. OK - so there's a bit of wiggle room on both sets of numbers but the fact remains that by the time SAP had reached Salesforce equivalency, it had successfully built up a business on modest capital requirements while managing to put some money aside. It should also be noted that SAP was not making acquisitions at that time as Salesforce has done but for this purpose we can ignore that.
Here's the problem
If - and it is a big if - you buy into the argument that growth is all that matters then fine. We're all good. But when you look at the fact that Salesforce has effectively burned a huge amount of capital and shows no sign of breaking even then there is clearly an issue smoldering away. And if you can argue that for Salesforce then it is not hard to argue that for pretty much every SaaS company, with some nuance around where each is at in the growth cycle.
If you look at what's been happening at Box where sales and marketing are, in my opinion, wildly out of control, then it is easy to imagine some company at some point imploding or, at the very least, having to put on the growth brakes very quickly.
Growth mavens argue that what really matters is the cash position and that as long as that stands up then all's well. OK. That in turn lends weight to the non-GAAP trick of awarding wads of stock options instead of paying salary. But as I've explained before, this requires an ever increasing valuation in order to remain attractive as a compensation tool for all but the very earliest employees.
Cash and prices
The research suggests that SaaS contract lengths are shortening to an average of 1.5 years. That would in turn suggest that you have to continue running hard to secure those deals and so safeguard future cashflow. With sales and marketing running at anywhere between 40-50% of revenue for your average SaaS company there is considerable potential to dramatically cut costs should the occasion arise. But that would be at the expense of growth, the primary factor upon which SaaS businesses have been valued during the last few years.
What are the alternatives? As far as I can tell, the only other lever left to pull is price. The last years we have seen SaaS costs to the end customer driven down significantly. What was once well outside the reach of the average SME is now well within its grasp. At the enterprise level, SaaS and other competition has driven some customers away from the traditional on premises suppliers and put price pressure on their offerings.
The general view is that customers can expect to make significant savings using SaaS but those vary considerably. Here's how you can view it:
- Salesforce says it has 150,000 customers (per its annual report.) These are now generating $5 billion in annual revenue. That equates to $33,333 per customer on average.
- SAP claims 235,000 customers and has revenue of around $22 billion. That equates to $93,617 per customer.
These figures are of necessity very rough and ready with considerable variation along the bell curve, but you get the general idea. And as I said before, Salesforce is losing money while SAP continues to turn a healthy profit.
So - in the race for growth - will prices rise? I cannot see a viable alternative and especially if the vendors get a whiff of any slowing down in sales growth trends. They will be well attuned to that through the data they already collect so it won't be hard for them to predict where things go.
Should you be concerned?
That depends on how you view SaaS economics. Most of the major vendors have seen the SaaS writing on the wall and are bracing themselves for a business model transformation. That is no guarantee that customers will see significant price cuts but then the incumbents who are wrestling with this problem don't have the same issues that the SaaS players have. They can afford to sit tight for a period of time and move at the pace that works best for them. If that means slower growth then so be it.
Despite the noises that some customers will 'never' go to the cloud, that timing issue is the only rational reason for suggesting hybrid cloud solutions.
Remember that while it is fun to make the Salesforce and SAP comparison, by the time 1992 had come around, SAP had been in business 20 years. Salesforce has got to the same growth point in 15. If that matters then fine, but my view is that customers are much more concerned about functional parity and while the SaaS push has been good for awakening the incumbent providers, they are very far from being a spent force.
What happens in 2015-16 will hinge upon how well the SaaS providers can continue to convince the market that SaaS economics play out to profit in the long haul and at a substantially lower cost base than the alternatives. The problem is that after 15 or more years, that has not happened. And growth or no, cash or no, history tells me that you can't trade on an forever in the expectation of a continually rising stock price.
Therein lies the way of madness.
Image credit: © Warakorn - Fotolia.com
Disclosure: SAP and Salesforce are premier partners at time of writing.