Erik Keller, former head of the enterprise software practice at Gartner [now heading his own shop, Wapiti LLC] authored an interesting piece at SandHill.com two weeks ago [thanks to a few of my fellow enterprise bloggers for reminding me about the post].
In the article, Erik takes a seemingly random group of 11 enterprise software vendors:
- Aspen Tech (AZPN)
- BEA Systems (BEAS)
- IBS
- Indus (IINT)
- Hyperion Solutions (HYSL)
- Manhattan Associates (MANH)
- Parametric Tech (PMTC)
- QAD (QADI)
- SSA Global (SSAG)
- Software AG (SAG.dax)
- Vignette (VIGN)
He then compares that group, in aggregate, to Oracle (ORCL) and SAP (SAP) in a variety of metrics. As you might expect, SAP and Oracle are prohibitively more efficient in all facets. One of the overarching points in Erik's piece is the notion of chronic over investment by software companies on SG&A...
When a value-oriented buyer's point of view is taken, the core of this inefficiency becomes obvious. From an income-statement perspective, the cost of delivering a product and service as well as R&D are customer value-adds: buyers get something direct and of value from these costs. On the other hand, sales and marketing as well as general & administrative expenses are seen as valueless to the buyer. They represent the overhead that a vendor needs to engage the market.
Enterprise software providers have conditioned sellers that they will lavish limitless time and attention on them for any type of deal regardless of buyer budgetary outlook and size. Though buyers may not realize it, they are paying for this inefficiency via bloated overhead costs. Unfortunately, for software sellers this behavior (and overhead) cannot be changed without a massive business reorientation.
He is absolutely right, and as an investor, I would embrace a more disciplined approach. Many times I've voiced my disappointment with the fact that few software companies deliver 20%-30% operating margins despite having 90%+ gross margins.
But perhaps Erik's most illuminating point relates to SaaS (Software-as-a-Service). Keller argues that SaaS, at least the current SaaS torchbearers (e.g., RightNow and salesforce.com) are no more efficient in their economic model:
While this is a different delivery model, it has not totally changed the dynamics of enterprise software selling. Salesforce.com and RightNow Technologies, two of the most well-received companies with a SaaS delivery and revenue model, both spend nearly 50 percent of their total revenue on software sales and marketing. Thus some of the old-software model company ills are well-represented for certain new companies that embrace a different business model. It is also far from clear how far and deep SaaS can be extended into buyer organizations.
About the only criticism I have with Erik's article is the "random" selection of enterprise software companies. The aforementioned list of eleven may be random on Erik's part, but it's decidedly uninspiring in terms of fundamental execution. It wouldn't be difficult to generate a list of 11 software companies that have demonstrably better operating margins and cost controls in place. But, the underlying point that the industry spends too much on SG&A and doesn't optimize return on invested capital would remain in place.
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Note: At the time of this writing, I and/or funds I maintain discretionary control over, maintained long equity positions in several of the companies mentioned but no short positions.
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