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The cloud's not-so-silver lining

July 18, 2008

At Business Week, Sarah Lacy has a good article on the daunting challenges that software-as-a-service companies face as they try to build vibrant, profitable businesses. Some traditional software powerhouses, like SAP, are spending a lot to develop web versions of their applications, but they have little to show for the investments so far. Pursuing two radically different business models simultaneously, they're running a race with their legs tied together.

Oracle, for its part, is deliberately moving slowly in shifting to the cloud model, preferring to milk the old, lucrative license-and-maintenance-fee model for as long as possible. Writes Lacy:

[Oracle] has offered a "hosted" version of its software for about 10 years, and CEO Larry Ellison clearly foresaw the on-demand wave, personally funding Salesforce.com and NetSuite. But spreading any kind of on-demand religion throughout his own company is another matter. Nowhere was this more clear than on Oracle's most recent earnings call. Why isn't Oracle a bigger player in on-demand software? It doesn't want to be, Ellison told the analysts and investors. "We've been in this business 10 years, and we've only now turned a profit," he said. "The last thing we want to do is have a very large business that's not profitable and drags our margins down." No, Ellison would rather enjoy the bounty of an acquisition spree that handed Oracle a bevy of software companies, hordes of customers, and associated maintenance fees that trickle straight to the bottom line.

More evidence of the challenges came yesterday with the announcement of Microsoft's disappointing profits for the last quarter, attributable at least in part to the weak results of its online services business. The company has been spending billions building big utility data centers, but the revenues generated by all that capital investment remain paltry.

Anyone who thinks the software-as-a-service business is a gold mine for vendors is wrong. The economics are fundamentally different from those of the traditional software business - and not in a good way. As Lacy writes, the Web is "just as good at displacing revenue as it is in generating sources of it. Just ask the music industry or, ahem, print media. Think Robin Hood, taking riches from the elite and distributing them to everyone else, including the customers who get to keep more of their money and the upstarts that can more easily build competing alternatives." Web apps remain a hard sell when it comes to big, conservative enterprises, and the capital and marketing costs are daunting, particularly if you're running your own data centers. This revolution in business software will play out slowly and, for most suppliers, painfully.

So far the smartest players appear to be Ellison and his former protege, Marc Benioff of Salesforce.com. The unsentimental Ellison will wait until the profits from traditional software begin to decay, and then will buy his way into the software-as-a-service business, cherry-picking attractive suppliers. Benioff wisely chose the right target for his initial web app - salesforce automation, or CRM, which had become an advertisement for the flaws of large-scale enterprise software - and has built his business over the course of a decade through steady technical improvements and relentless marketing (aimed at both customers and investors).

"On-demand software," Lacy writes, "has turned out to be a brutal slog." Don't expect it to get easier anytime soon. Success will come to a few smart, tenacious companies, but it will be hard-won.

Comments

Successful SaaS companies are going to need the distribution economics of open source. SugarCRM comes to mind as an example of where both on-demand and open source companies are headed.

Posted by: Chris Marino [TypeKey Profile Page] at July 18, 2008 10:25 AM

Given that the "as as service" world is simply about the shift of ubiquitous activities from a product to a service based economy, then competition based on price and quality of service in marketplaces of common services with portability & interoperability between vendors seems logical. Unless of course you're a vendor for a common product who is not willing to accept a new reality. It's tough really, but that's the Red Queen for you, the constant need to adapt to the marketplace just in order to stand still.

Portability and interoperability between providers is necessary for all the usual user concerns of second sourcing - price competition, security and so forth. Shifting the mentality of product differentiation into a service world is not only counter to second sourcing, it makes little sense for something which is becoming ubiquitous and well defined.

The most logical route is for the entire service to be open sourced, encouraging the formation of markets and hence emergent standards.

We've been seeing some of that recently and interestingly at CloudCamp London, when asked, most participants thought that interoperability and portability between providers was important and that this wouldn't be achieved with proprietary technology and standards by committee.

So I have to agree with Chris on the importance of open source but this won't be an exclusive situation in much there same way that there will be niche product areas and there will also be plenty of new lucrative opportunities from the establishment of commodity markets in computing resources.

As for Ellison buying his way into the market as traditional revenues decline, it of course makes complete sense to maximize existing revenues that are being cannibalised. However, the rub here is the same with any disruptive innovation, the switch of consumers can quickly become a flood and not a trickle and many traditional players will be trying to shift into the new space when it does. Timing will be critical and there will be casualties from this shift.

Of course, as big as this change is, it is potentially small fry compared to the looming commoditisation of the manufacturing process itself through digital fabrication technologies. The combination of open source to hardware with digitisation of fabrication techniques and an approaching future of machines printing machines promises a whole new world of commoditisation, componentisation, accelerating innovation and ever more creative destruction.

But then, this has been going on for donkeys years.

Posted by: Simon Wardley [TypeKey Profile Page] at July 18, 2008 12:01 PM

Reminds me of that article from 1984:

Desktop Computing: A Brutal Slog
"The tough reality of the PC market is taking its toll on software companies hoping to make a mint distributing their wares via the desktop"

do I need to extend the analogy further?

Posted by: Nik Cubrilovic [TypeKey Profile Page] at July 18, 2008 03:36 PM

>> Timing will be critical and there will be
>> casualties from this shift.
PC based in-house software is synonymous with corporate socialism - thousands of redundant jobs that could be eliminated with SAAS. With the tech industry running to DC begging for more cheap foreign labor, massive layoff would kind of contradict their claim of worker shortages. Go figure!

Posted by: Linuxguru1968 [TypeKey Profile Page] at July 18, 2008 04:39 PM

At some point Microsoft will just flip the switch and start encouraging its users to move into the cloud. There's still plenty of time for them to establish themselves as the biggest player in the cloud computing.

Posted by: Charlie [TypeKey Profile Page] at July 18, 2008 08:25 PM

Nick - Agree that reaching the core of the enterprise is going to be a long, difficult process with high marketing and capital costs – but I disagree that traditional vendors like Oracle can buy their way in when traditional business begins to decay, especially by picking off a collection of attractive vendors.

The successful SaaS vendors for the foreseeable future are the “best of breed” vendors that can carve off a departmental application for SMBs and even enterprises.

Vendors like Salesforce.com, who sell to buyers via online, customer-initiated self-service complemented by inside sales that often becomes the viral “discover, learn, try, buy, recommend” process articulated by Ray Ozzie. They experience much faster success than vendors like Netsuite that have to make a corporate sell of a full suite that takes much longer and flattens the growth curve. SFDC and Netsuite are approximately the same age and SFDC is roughly 7x the size and far more profitable.

The problem with penetrating the core of the enterprise (financials, order management, industry-specific functionality such as manufacturing or securities processing or an end to end suite) is that the real TCO promise of SaaS hasn’t been proven – even with, or especially with, departmental applications. Sure, the upfront costs are measurably lower. But we haven’t been through a full 7-10 year product lifecycle. Besides the monthly subscription costs there are expenses for business process reengineering, configuration, data migration, and by far the biggest and most unknown: maintaining interfaces to legacy or other departmental systems. These change whether you’re deploying SaaS or client-server systems. What today looks like an attractive, manageable, departmental deployment over time might look as crushingly complex to maintain as client-server best of breed deployments.


The problem for someone like Oracle buying their way in when their traditional business starts to decay is that they would have to pay an enormous cost. The amount of shareholder capital they would have to give up would be compounded by two issues. Once investors discount the decay in their traditional business and simultaneously discount the heightened prospects for vendors like SFDC, ORCL’s relative market cap, now 11x SFDC’s, would shrink dramatically. Even without a relative change in market cap, Orcl would be paying out roughly 10% of shareholder capital for what is essentially zero incremental profits. That sort of dilution would be challenging to swallow all at once.


Vendors are going to be able to deliver on the promise of SaaS across the core of the enterprise. But it will be a long, slow process of leveraging a direct sales force with a new breed of ISV-type partners and a patient process of maturing what will likely have to be an end-to-end suite. So far Workday and SAP have indicated this is their preferred path. Maybe Oracle will also be able to remake its On Demand product into something that can deliver the still-to-be-proven TCO benefits of SaaS.

Posted by: GGilbert [TypeKey Profile Page] at July 21, 2008 08:52 PM

Posted on the Wikinomics blog: www.wikinomics.com/blog

Sorry Carr, The Cloud Looks Silver from Here

Nicholas Carr is a well-respected thought leader who we have agreed and disagreed with in the past (see here and here). A few weeks ago, he posted The Cloud’s Not So Silver Lining as a response to Sarah Lacy’s article in BusinessWeek. Once again, Mr. Carr, we respectfully disagree, and hope to have a spirited debate on the topic and we would appreciate the comments and insights from both our readers and yours.

He describes how the software as a service (SaaS) model and on-demand computing is not a gold mine for software vendors.

Anyone who thinks the software-as-a-service business is a gold mine for vendors is wrong. The economics are fundamentally different from those of the traditional software business - and not in a good way. As Lacy writes, the Web is “just as good at displacing revenue as it is in generating sources of it. Just ask the music industry or, ahem, print media. Think Robin Hood, taking riches from the elite and distributing them to everyone else, including the customers who get to keep more of their money and the upstarts that can more easily build competing alternatives.” Web apps remain a hard sell when it comes to big, conservative enterprises, and the capital and marketing costs are daunting, particularly if you’re running your own data centers. This revolution in business software will play out slowly and, for most suppliers, painfully.

Carr is right; the economics are fundamentally different from those of the traditional software business. However, they are different in a good way. Just like how utility companies changed the electric power game by drastically reducing costs, cloud computing and SaaS vendors will change the software and server game. Carr even made this same argument in his book, The Big Switch. “What the fiber-optic Internet does for computing is exactly what the alternating-current network did for electricity.”

The problem SaaS firms are having is that they are relying too much on the technology and the medium of distribution, and not on the service. Salesforce.com has been successful and the “poster boy” of SaaS because it provided a better CRM system than what was already available.

Steve Papermaster, the CEO of nGenera said at a recent SaaS panel discussion that SaaS vendors must provide new functionalities in order to succeed: “[SaaS] changes your billing cycle, but doesn’t change the game for the customer…If you’re not providing disruptive change in the positive sense for customers so they can run and lead their business very differently from before, then you’re not providing breakout value.” As soon as more vendors realize this, on-demand computing WILL become a gold mine for SaaS vendors. If the end product to the enterprise is ultimately more valuable, SaaS vendors don’t necessarily have to charge significantly less than the offerings of current vendors.

Most SaaS vendors are targeting small and medium sized businesses (SMBs) where the margins are much smaller. For SMB’s, SaaS makes more sense as they are unable to pay the high fees of traditional vendors. This current practice results in what Lacy described as Robin Hood taking money from the rich and distributing it to the poor. However, Papermaster continues, “the issue is not so much one of ‘is SaaS going to be acceptable to the enterprise,’ it’s rather how will it be possible for an enterprise not to run globally on demand?” Both large, traditional companies and SMBs alike will be forced to make the switch, as the level of service will be so much greater than what the traditional vendors are offering. For larger companies, vendors can include value-added service and consulting work on top of the basic platform to justify charging a higher subscription fee.

Current economic arguments aside, the companies soon to be staffed by the Net Generation won’t just appreciate always on SaaS applications, they’ll expect them. This hyper-connected, tech-savvy generation will not tolerate upgrade cycles, instead expecting the daily improvements and tweaks only SaaS vendors can provide.

Although both Carr and Lacy recognize that cloud computing and SaaS is the future, the future is a lot closer than they think.

Posted by: BLetalik [TypeKey Profile Page] at August 12, 2008 01:36 PM

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