Software Maintenance Revenues Under Pressure...AKA, the "Other Shoe Is Dropping"

As license revenues have become harder to come by, software vendors have become more reliant on ongoing maintenance revenues. For the uninitiated, most software vendors charge a one-time [perpetual] license fee upfront for the use of their software and then charge an annual fee [usually in the range of 14%-18% of the initial fee] for maintenance & support; which entitles customers to all future enhancements and upgrades of the software.

While license revenues have always been the sexy metric among the investment community, it's the maintenance revenue streams which are predictable [i.e., every year], profitable [no wooing new customers, just sending a bill to an existing one] and secure [once a customer has spent big upfront $$$ on software code and more on installation, they often view maintenance as an unavoidable follow-on expense].

But according to several sources, this may be changing...which would spell significant problems for the enterprise software industry in my view.

Special thanks to my friend and colleague Mark Gomes at Pipeline Data LLC for the diligence on this topic. Mark is the former head of investment research at AMR Research and has branched out into his own high-value strategic consulting business. Without his synthesis of the datapoints, I probably wouldn't have taken this issue as seriously as I now do.

In essence, there is anecdotal yet compelling data to suggest that enterprise software customers are no long taking their maintenance fees for granted.

• Customers are pushing back on maintenance pricing [much in the same way they've always pushed back on initial license terms]
• 3rd party maintenance & support firms are cropping up and gaining notoriety...including TomorrowNow, Rimini Street and netCustomer to name a few. These firms are promising [and delivering] enterprise-class support for significantly lower fees; giving customers something they've not had in the past -- CHOICE.
• Larger enterprises are opting to maintain maturing software in-house, as the available supply of capable IT personnel is reasonably plentiful

The outcome remains uncertain but enterprise software vendors can ill afford to lose control of this revenue stream. Possible outcomes of this trend [if in fact it is a trend]...

1. Software vendors are forced to offer more flexible maintenance contracts
2. A percentage of larger vendors opt out of maintenance entirely
3. Software vendors more aggressively pursue alternative delivery methods like subscription-based pricing or Software-as-a-Service [SaaS]
4. Vendors utilize discounted maintenance and support for competitive products as a tool to encourage migration to their own offerings [i.e., SAP buying TomorrowNow to woo Peoplesoft clients away from Oracle]

Whatever the outcome, this is NOT good news for enterprise software companies. Barring a massive resurgence in license revenue bookings, this could well be the other shoe to drop in terms of maintaining a trajectory of revenue growth and margin expansion.

From an M&A standpoint, this raises a potential red flag, as well. A vast majority of the M&A in the sector has been driven by paying a multiple on ongoing maintenance revenues. Oracle has made no secret of its desire to leverage the considerable maintenance streams from it's 11+ acquisitions. And other acquirers, private and public, have also been justifying purchases on the presumed NPV of future maintenance revenue streams. That may prove to be flawed logic in some cases...time will tell.

Note: I and/or funds I maintain discretionary control over may have held long equity positions in some of the firms mentioned but did not maintain a short position in any company mentioned.

software apps pricing woodrow SAP Oracle Peoplesoft TomorrowNow Rimini netCustomer M&A investing

Comments

[vinnie mirchandani]

The biggest erosion comes in 2 areas

a) companies who feel they are stable enough or do not believe the vendor will have much compelling stuff for 3 -5 years can easily move to own or 3rd party maintenance (which cannot provide upgrades). In SAP and Microsoft's case many customers want to get off the upgrade treadmill. In Oracle's case many do not believe something stable or wrothwhile will be abailable short term

b) another subtle way maintenance erodes is it is tied to initial list price. So as vendors discount license list by 70, 80 even 90% it affects the maintenance tail...

but gross margins are still so high around maintenance - 90+%...vendors have been naive to think this could go on and on...

BTW - some vendors charge way more than 18% ---some in mid 20s, some even in 30s -