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Introduction

Each quarter we hear bad financial news from large traditional enterprise software companies. This week (the week of April 20, 2015) saw profits at SAP drop from the same time last year and IBM reported their 12^th consecutive quarterly loss. Similar profitability problems have been reported at other traditional software companies[1]. The current reasoning is that these are short-term problems driven by the transition to cloud computing. It makes logical sense. Cloud computing has a different financial model with subscription revenue deferred to a later date while expenses associated with that revenue are spent in the here and now. If the move to cloud computing is the culprit, then it would be expected that there would be rising cloud revenue, shrinking non-cloud (traditional software) revenue, and drops in operating profits. There would also be increasing deferred revenue as well.

But is this the case? And if so, what can a customer expect?

An analysis of SAP financial information, available on the SAP website, suggests that the “cloud transition” explanation for dropping profits is on target. While operating profits have been dropping and may continue to do so in the short-term, this is not a terminal situation. Temporary decreases in profitability are mostly irrelevant when traditional software companies are making the right kinds of investments. Investing in cloud computing, along with mobile technology, is clearly a positive type of investment.

Analysis

SAP’s software revenue overall has continued to increase with dramatic increases in cloud revenue. Cloud revenue jumped ~1400% from 2011 to 2012 according to International Financial Reporting Standards (IFRS[2]). However, since SAP started with relatively miniscule cloud revenue versus traditional software revenue – €18M versus €11.3B in 2012 – that increase is deceiving.  Between 2013 and 2014, year over year cloud revenue growth was still a healthy 56% though. At the same time, traditional software revenue growth was more in line with typical software revenue growth, 16% in 2011, and 14% 2012, before falling into the low single digits.

As cloud software revenue continued healthy growth, traditional software growth slowed dramatically. On the surface, it would appear that cloud computing was growing at a startup’s pace while the traditional software business had ground to a halt. This is exactly what would be expected during a major transition in the software market.

A look at operating profits, on the surface, is more worrisome. For the past three years, starting just as cloud computing growth began to grow significantly, operating profits have been basically flat. At the end of 2014, operating profits has actually dropped by 3%.

This pattern has continued into the first quarter of 2015 as well with year-over-year quarterly revenue for the cloud business increasing by some 129% and traditional software revenue growing by a respectable 12% but operating profits decreasing by 12%.

The Cloud Transition Effect

It’s obvious then that cloud revenue is increasing and traditional revenue growth is staying positive, albeit with smaller gains, while operating profits is dropping.  This would appear to be exactly as expected by the cloud transition effect if it can be attributed to changes within SAP that support such a transition.

It would appear that it does. R&D expenses, for example, have increased considerably, up 35% since 2010. Employee headcount (in terms of FTEs) has also increased by about 39% in that same period. This type of spending has all the earmarks of a investing in a future market (more R&D and people) at the expense of profitability in the present.

Another possibility is that the margins on the cloud business are much lower than the traditional software business and, as cloud revenue grows, profits will be hurt. If that is the case then these type companies would be in danger. That seems unlikely since the contribution of the cloud business, for all its high growth, is still very small compared to on-premises software. In the first quarter of 2015, the traditional software business was still 86% of total software and cloud revenue. Even if cloud software had tiny margins, margin pressure would not have this type of outsized effect on profitability.

We are left therefore with the conclusion that the most likely reason for declining profitability in large established enterprise software companies is increased spending to support a transition to cloud computing.

The Outcome of This Transition

Traditional enterprise software companies are clearly going through a transition which carries with it a very different revenue model. Software used to be a capital expense with many upfront costs and a yearly support cost. Instead, cloud computing turns this CAPEX[3] into a monthly or yearly subscription. This has two effects for software companies. First, it locks in revenue for the long term. Investments made today will pay off far into the future as subscriptions continue forward. SAP deferred cloud revenue grew some 76% in Q1 2015 compared to the same time last year. This number will continue as more customers switch to cloud computing.

Second, revenue will be more evenly distributed. Over time, highs and lows of revenue will be less exaggerated as big spikes from large new deals and seasonal upticks from renewing maintenance will be less pronounced. Software companies will have to watch customer churn more closely since the costs of a rip and replace project will more subdued. Even so, considerable barriers to changing vendors will continue to exist. The cost of customization and training haven’t suddenly evaporated, to say nothing of the disruption of the business when a major enterprise application is changed. Overall, subscriptions favor the status quo and once an enterprise cloud application is part of the fabric of a company it is likely to stay that way even through reasonably[4] rising subscription costs. Ultimately, the move to a subscription model for software will leave traditional software companies even stronger as lower upfront investment makes it easier to sell software while more traditional factors keep customers from switching.

Conclusion

Why does this matter to customers? In a word “confidence”. It would be normal to look at the financial news from companies such as IBM, SAP, and Oracle and wonder if an investment in their software is a good bet. The dire headlines from both IT and financial press would give any prudent IT manager pause. However, the important figures to consider are the revenue numbers. If large enterprise software companies are spending for the transition to cloud, then they are making the kind of wise investments that will produce a more healthy company in the future. At some point in the near future, the growth in cloud software revenues will slow, the decline in traditional revenues will also slow, and a new homeostasis will be reached.  There will be increased competition from new cloud software companies of course. That will give customers choices and help keep subscription costs from increasing dramatically. Costs, however, are only a part of the software purchase decision. Functionality, service, and relationship matter as much as cost and vendor stability. If the best fit is software from a large traditional enterprise software company, then there is no reason to hesitate.

[1] A traditional software company refers to large companies that sell enterprise applications that did not begin by selling cloud applications. Oracle, IBM, and SAP are traditional software companies whereas Netsuite and Salesforce.com have always been cloud software companies.

[2] The International Financial Reporting Standards (IFRS) is a set of accounting standards that is intended to be common across international boundaries.

[3] Capital expense

[4] The key term is reasonably. If software vendors get greedy and drive up costs, the plethora of choices with fewer barriers to change will certain move customers to consider alternatives.

 

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