I2 in 1996 went from $20 a share to $111 a share in 2000 and then to 41 cents in 2002. “Writing off the value of acquisitions that never lived up to their promises caused I2 to lose nearly $8 billion in 2001. Revenues in 2002 showed that I2 never really had a billion dollar business. In 2001, according to the restated financial information it cost I2 about $1.32 for every dollar of revenue. Including all operating charges and expenses, in 2001 it cost I2 $9 for every dollar in sales. In 2001-2002, I2 sold more “service-like” items (maintenance, product enhancements and upgrades, and customized contracted software). Service being the slow impoverishing factor. Between 1999 and 2002, $950 million in software license fees required the company “to perform services that are essential to the functionality of our product.” I2 products were complex hybrids requiring time and expertise to install, tailor, and integrate into customer’s information systems. The software was difficult to sale in high volumes. Once installed, Customers claimed to realize major cost savings and large returns on their I2 investment. A large part of I2 technical organization was located in India, where costs were lower. CEO, Sidu said, “After growing 97 percent in 2000, total revenues fell 12 percent to $986 million, and in the second quarter, I2 reported its first quarterly pro forma loss.” I2 need a wider group of satisfied and loyal customers; Sidu classic MBA style management solution shifted away from establishing a horizontal product platform with established short term and long term contracts, towards cost cutting measures, he says, “As customers slowed spending, we reduced our quarterly cost structure by more than $100 million from the first to the fourth quarters. We reorganized our operations, reduced our workforce, refocused sales forces, consolidated offices, reduced discretionary expenditures and began transitioning more research and development to India, where we have a 3:1 cost advantage over developing in the US.” Large profits result from the manufacturing of products and then follow with service contracts. However, when times become bad, revenues collapse and customer stop buying new products. The companies most likely to survive are those with a loyal and satisfied set of customers who pay recurring fees over long-term contracts for product updates, bug fixes, customization, and other services. If product sales do not resume then the service and fees will not be enough to save the company. “What I now realize, all too painfully, is that this potential failure to buy puts the revenues of software products companies as considerable risk” - short term for 3-5 years. Services revenues during the I2 boom grew faster than the product sale revenues. “Software companies can double or triple their revenues over time through accumulation of contracts for services and custom software, including maintenance, even if new software product sales lag behind in growth.” “Over the lifetime of many enterprise software products, 70 percent or more of the total cost to a customer comes from service and maintenance fees and only 30 percent from the original product sale.” The product verses service tension occurs because “they know they must eventually move toward selling more labor intensive and less profitable service.” “It is also possible for software product companies to gravitate too much toward services and ruin the potential of their product business.” Many times customization is required to get customers; the service portion of these revenues rise; installations and upgrades become more complex because they have to include the enhancements. It takes to time to establish a standardized product.
Business Object grew consistently with steady profits from 2001-2002. Business Object was simpler to install and customize. Between 1993 and 2002, Business Objects went from 18 percent services and maintenance to 46 percent; Oracle went from 40 to 64 percent; Siebel went from 5 to 57 percent; SAP went from 50 to 69 (1997-2002); IBM went from 58 percent to 74. The ERP companies understand the need to tailor products to customer or go out of business. As a result ERP companies are generally more oriented towards service and hybrid solutions than products. SAP revenues in 1997-2002 rose from $2.7 billion to $6.9 billion and employee increased from 11,558 to 28,604; SAP grew rapidly by hiring rapidly; so the company is not an exception and the trend can not continue forever.
A company starts out in a vertical market, gain market share, and then slowly expands into a horizontal market. Small companies usually do not have the resource required to build a product that can compete effectively in a horizontal market capturing larger and larger percentages of market share. The author states concerning his experience with high technology companies, “During these years, I believed and I think most venture capitalist, managers, and entrepreneurs also believed, that it was much better to be mainly a products company. I no longer think this is true.” Software companies should want to sell a lot of copies of product. Companies that get heavily into customizing their products for each customer and “providing services such as strategy advice, training, and integration work with other software systems, as well as selling large amounts of maintenance and technical support have become a service company. Service companies are labor intensive organizations with lots of unique projects. Companies like “PricewaterhouseCoopers, EDS, Accenture, and Cap Gemini Ernst & Young are IT service firms”. Microsoft or adobe are pure product companies.
Basic Financial Metrics: 1. Industrial analyst place a high value on the percentage of a software company’s revenues that com straight from licensing fees and the growth rate of this percentage over time (growth and stable sales). 2. Another measurement is sales productivity, or revenue per employee – 200k per year per employee for a company to be profitable. Companies can have high sales productivity and still lose by overspending in R&D, marketing, and administration. Sales and Marketing 25-30 percent of total revenues, R&D 10-15 percent, general administration 5 percent, and profit margin 20 to 30 percent. “Again, high revenues and profits per employee – and low costs relative to revenues-are much easier to achieve if you have a best-selling shrink-wrapped software product.” Firms cannot charge too much for services. There are many India companies that can do the work for less or the company may decide to do the customization. “Software vendors that do mainly custom development or service work can also make lots of money, but only as long as they hire lots of people.” “A products company should have well over half of its revenues coming from new sales of software products.”
The difference in gross profit margin between selling licenses verses service is amazing; Business Objects, in 2002 sold $244 million in licenses with $3 million attributable to costs for a 99 percent profit margin; Business Object service revenue of $211 million consumed $71 million in costs, for a profit margin of 61 percent. Business Objects had R&D costs of $75 million or 16.5 percent of sales; in 2002, Business Objects had sales and marketing expense of $222 million or 49 percent of revenues). “Software products are generally much more profitable than services and maintenance revenues, and easier to growth without adding head count.”
Horizontal Market case study of Skyfire: Started with three people, received $4 million in venture capital, and top off at 25 employees before exhausting. Skyfire platform allowed developers to port PC applications or develop them for wireless handheld devices. The company tried to go for a horizontal market, immediately; trying to get Microsoft, Nokia, Palm to embed Skyfire technology into their operating systems or server software building wireless applications that ran lean. “Imagine that you could securely and wirelessly connect from your PDA, laptop, or home PC to all the applications and data that reside in your office”. “Good enough” prevailed; Microsoft had backoffice and dot net framework to sell; Palm had Code Warrior, and Nokia had its own technology. Skyfire thought they had a competitive advantage, saying “Our technology includes unique compression, encryption and transmission techniques, and device software that automatically enables any wireless device to perform like a computer terminal connected to the network.” “The horizontal market could have been a bonanza for the company, but it provided impossible to crack.” Vertical markets would have been easier to conquer. Every software company should periodically reevaluate its products to determine if it is getting the breadth of offerings right. The danger is bundling weak products with strong ones and not improving them. “Horizontal markets can require enormous investment and skill to master.” “Once a company has crossed the chasm into the Early Majority with at least a niche product, it can be used as base to expand into other segments.” Look for related segments to leverage the technology expansion. Increasing sales force during the Early adopters is not preferred, because early adopters are not a strong reference source. The tipping point is 10 percent market acceptance.