Economic Stress Test
For The Software Industry: Will Your Company Pass?
By Chris Dowse, Founder and Chief Executive Officer and Ben Galison, Principal, Neochange
What
does the smart money know? What has the economic
meltdown exposed?
On May
22nd the stock market had valued the software
industry at a 3.7% discount to the S&P500, based on
the next-12-month price/earnings ratio. This isn’t
particularly striking until we consider that for the
past five years, the software industry has on
average been priced at a 34% premium to the S&P
500.
What
could account for this dramatic difference?
While
there is definitely widespread uncertainty as to the
timing and size of an economic recovery, a swing of
this magnitude suggests the market believes
something has fundamentally changed the software
industry’s future capability to generate earnings.
It is an indication that the market believes a
structural shift is taking place and that the
outlook for the coming year is dire.
THE
PERILS OF SWIMMING NAKED: DOES THE SOFTWARE INDUSTRY
DELIVER VALUE?
Warren
Buffet has a saying, “It's only when the tide goes
out that you learn who's been swimming naked”. He
goes on to point out that during good times we don’t
know how much risk exists within any given company
–the degree to which a management team has
potentially exceeded sustainable levels of the
economic drivers for their industry.
The
financial services industry provides a familiar
example to illustrate this situation. As the
economic crisis dawned, many financial company
executives continued with risky business practices
despite the warnings that the “gravitational
relationship” between housing prices and incomes had
been exceeded. In the banking industry, these
economic drivers are well established, studied
thoroughly and reported regularly. In the software
industry, economic drivers of revenue and benefit
are somewhat less obvious and more difficult to
measure; however, data does exist and it presents a
disturbing picture.
Software-driven productivity stalled well before the
economic crisis
Figure 1: Comparison
of software investment against software driven labor
productivity growth
Source: Neochange
analysis of Federal Reserve Board and Credit Suisse
economic data.
A 2007
Federal Reserve Board report on US labor
productivity reveals that the software industry had
exceeded the “gravitational relationship” of
software investment levels (customer spending) and
software-driven productivity (customer value
delivered)well before the economic crisis
started.Figure 1 compares the contribution of
software to US labor productivity improvement –a
macro-level measure of software-driven business
benefit –and the relative level of software
investment as a percentage of US GDP.
The
Graph shows that since 2001, software spending moved
consistently with the growth of the economy (at a
flat rate of around 1.5%, but over the same period
the improvement in growth attributed to software
declined nearly 40%. While resolving this value
delivery gap will require tackling some complex
issues, there are two certainties that will drive
and shape the software industry’s future beyond the
economic crises.
1.
Software cannot deliver value if its adoption is
ineffective–Study after study (Butler Group, Neochange/Sandhill6, CRM Magazine) evidence the
fact that most enterprise software is still poorly
adopted, regardless of application type. These
studies consistently peg average adoption rates at
less than 50%. Neochange’s own research indicates
that 2 out of 3 buyers realize less than 50%
effective usage. This is less an issue of shelf
ware than it is a problem with companies not using
software effectively to deliver value. As one IT
analyst describes it, companies are “oversoftwared.”
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2.
CIOs are on a long-term mission to reduce total cost
of ownership (TCO) and prove IT value–CIOs are
accountable to their organizations for the ROI on
technology investments, and they are not happy. CIOs
need to see a positive change in ROI: as such,
spending will go down until value delivered goes up.
Regardless of the causes, customers are not
harnessing the value of their software investments
and they not only need, but expect help from their
software providers. |
The
economic squeeze has forced IT organizations to cull
software investments that do not deliver. These
changes in customer behavior and value expectations
are fast-paced and represent a significant threat to
ISV revenue and earnings. This threat will
materially reshape the economics of the industry.
The next 12 months will reveal which software
players have been “swimming naked.” Software
companies can expect their very viability to be
tested.
A
STRESS TEST FOR ISVs: WILL HEADCOUNT REDUCTIONS BE
ENOUGH?
As a
measure to stabilize the financial system, the US
government created a “stress test” for banks.
“What-if” scenarios were designed to determine
whether banks could survive the possibility of
worsening economic conditions and to enable them to
take corrective actions if it appeared they could
not. Current economic conditions have already had a
material impact on revenues in the software
industry. Recognizing that economic conditions will
worsen, how can ISVs gauge their risk? |
Below
are three scenarios that ISVs could face within the
coming year, which individually and collectively
would test the limits of many vendors. Figure 2
describes the revenue impact of these scenarios.
Figure 3 documents industry events and trends to
substantiate these scenarios and the magnitude of
their risk |
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Figure 2
Company Revenue Impact Under ISV Stress Test
Scenarios |
Scenario 1:20% Reduction
in Maintenance / Subscription Revenue |
Scenario 2: 50% Reduction
in Professional Services Revenue |
Scenario 3: 25% Reduction
in New License / Upgrade Revenue |
• Maintenance renewals
continue trend of 5% quarterly reductions9
• Heavy discounting on 2008
deals drives down average maintenance
contract values for years
• Customer pressure for price
reductions increases to meet internal IT
budget cuts set beyond 2009. |
•Customer discretionary IT
spending cuts target the price points of
implementation / integration services
•Powerful user groups
introduce KPIs for reducing total cost of
ownership (TCO) and optimizing business
processes as conditions for maintenance
fees, thereby cannibalizing existing
services10
•Sales cycles continue to
draw out as customer purchases require
additional levels of approval and ROI is
further scrutinized |
•Sales cycles continue to
draw out as customer purchases require
additional levels of approval and ROI is
further scrutinized
•Advances in software
utilization tracking provide usage
visibility to justify delaying upgrades
until returns on prior purchases are
realized |
Figure 3:
Economic Stress Test for ISVs: “What-if”
Scenarios with Associated Drivers |
Could these scenarios become a reality for your
company?
Executive teams are not standing still –many have
announced and implemented cost reduction activities
to protect earnings in the short-term. Reducing
headcount will help software companies weather a
short-term earnings dip, but for long-term
viability, ISVs will need to create strategic
blueprints for helping customers succeed with
effective product adoption and value realization.
Software leaders should take the following actions
to strengthen their companies.
NO
BAILOUT IS COMING: SOFTWARE EXECUTIVES NEED TO ACT
NOW
1. Align
the Leadership Team to a Customer Value Mindset
The
biggest barrier to the software industry’s future
success is the outdated mindset that software
companies are in the product/feature business. In
actuality, services have for years dominated the
customer’s total spend to reach software-driven
value. Buyers do not want software per se; rather,
they are after the value that software delivers:
increased sales, operational efficiencies, and
product innovation. This does not mean ISVs should
not strive to be world-class product providers. But
product innovation is ultimately pointless if
customers are unable to derive value.
The
first step to move a company forward is refocusing
the leadership team on customer value. Executives
need to adopt as a guidepost a shared vision of
customer value realization linked directly to their
company’s products, services, operations, and
partners. Getting the CEO on board is paramount. The
CEO must be convinced that the current earnings
shake-up requires a longer-term investment in
customer success, ahead of the sole pursuit of
product innovation. Unless the CEO is willing to
shift business priorities and redirect company
efforts and investments to address the adoption
problem, other actions will have little impact.
As the
software marketplace has evolved, the bar has been
raised for ISVs across the industry. Customers
expect their vendors to be complete solution
providers, delivering innovative products with high
levels of operational excellence and customer
intimacy. At this stage of the industry’s maturity,
providing services that enable customer success with
products is a necessity for ISVs, not a nicety. It
can also be economically attractive. TPSA member
research has shown that customer accounts with
professional services investments produce almost
triple total revenue and achieve higher renewal
rates.
2.
Institutionalize Customer Success Across Company
Silos
Once
leadership is committed the vision of customer
success should be put into operation across the
company. Nominating a Chief Adoption Officer (CAO)
is a powerful step and visible sign of commitment.
Some forward-thinking ISVs have already created this
new, cross-functional role reporting directly to the
CEO.
A
cross-functional perspective is essential. In many
ISVs customer knowledge is fragmented, trapped in
silos. Leaders must work across these silos
–particularly the services, support, and sales
functions –to ensure that key customer information
is brought back into the organization, shared among
employees, and put to use enabling customers to
succeed.
Company
metrics must also be aligned to adoption and
customer value objectives. Reorienting goals and
rewards at both the executive level and throughout
the ranks is necessary to accomplish the wholesale
shift in behaviors and mindsets. For a company to
transform, its metrics must change.
3.
Lead the Customer Through Value-Centric Sales and
Service
As the
ISV reorients toward customer success, the
organization fundamentally moves from being in the
product business to being in the productivity
business. Value assurance becomes the focus
throughout the entire customer lifecycle, including
sales. Adopting a “value-delivered” approach to
sales and initiating value/ROI discussions early in
the sales cycle puts the customer relationship in
the proper frame right from the start. Arming the
sales force with a “value path” that maps product
capabilities to customer value drivers enables ROI
to be transparent, convincing and measurable. In
addition to reshaping the sales cycle, this
evolution brings a greater importance to services
that drive adoption and effective usage of the
product.
The
Neochange/SandhillGroup software survey found that
95% of buyers want their vendors to take a
leadership role in driving adoption and the
achievement of value. The same survey also showed
that 80% of buyers are willing to pay for value
assurance services to enable effective usage.
80%
of buyers are willing to pay for value assurance
services to enable effective usage.
The
question for ISVs is which value assurance services
to offer?
Which services do your customers most need?
Which will differentiate you from your competitors?
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Large enterprise ISVs are already succeeding
through wise choices on this front. Oracle’s
Advanced Customer Service group, for
example, delivers services aimed at reducing
customer costs and optimizing customer
business processes. Other value assurance
services may include ROI acceleration
offerings, business domain maturity
assessments, or change leadership
assistance.
Whatever the scope of the service portfolio,
it is unlikely that any one company can
deliver everything with quality. As such
ISVs also need to strengthen and effectively
lead partner ecosystems in the delivery of a
solution-centric approach. ISVs can no
longer end customer services at the
implementation / integration stage and
expect to drive sustainable growth. |
Large
enterprise ISVs are already succeeding through wise
choices on this front. Oracle’s Advanced Customer
Service group, for example, delivers services aimed
at reducing customer costs and optimizing customer
business processes. Other value assurance services
may include ROI acceleration offerings, business
domain maturity assessments, or change leadership
assistance.
Whatever the scope of the service portfolio, it is
unlikely that any one company can deliver everything
with quality. As such ISVs also need to strengthen
and effectively lead partner ecosystems in the
delivery of a solution-centric approach. ISVs can no
longer end customer services at the implementation /
integration stage and expect to drive sustainable
growth.
Software executives face a once-in-a-lifetime
challenge.
Ironically, it is customer adoption, the bottleneck
to sustainable growth, that will be the path forward
and out of the revenue trough that software
companies are experiencing. The current economic
adversity impacting customers will permanently raise
the threshold for software companies to become more
customer-centric and value driven. Although this
trend existed before the meltdown, the pressure to
reduce costs has accelerated changes, bringing new
levels of ROI scrutiny and accountability.
Thankfully, the arc of technology history is strewn
with stories of innovation in which companies rise
through adversity and drive future growth. The
survivors of the next twelve months will be those
companies that recognize the permanent shift in
customer behavior and expectations that has occurred
and create their own internal "stimulus package"
focused on efforts to drive customer success. |