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Applications

Posted by iBlog on January 6, 2008

The online delivery of software—sometimes labeled software as a service—has been a long-standing dream for some vendors and CIOs. The concept is simple and attractive: rather than buying a software license for an application such as enterprise resource planning (ERP) or customer relationship management (CRM) and installing this software on individual machines, a business signs up to use the application hosted by the company that develops and sells the software, giving the buyer more flexibility to switch vendors and perhaps fewer headaches in maintaining the software. For many years, traditional software vendors (those who sell licensed and packaged software, often along with a maintenance contract) have been able to overlook a rising crop of competitors that offer software as a service, as the latter have struggled to develop truly competitive services. It’s now time for traditional companies to pay attention, for they risk losing their privileged position to attackers that offer applications in this new way.

The complacence of traditional vendors is easily understood in light of the record: the first generation of online software delivery, in the late 1990s, failed to meet the reliability and quality standards demanded by business users. But the new delivery method appears to be taking off. While it won’t replace existing licenses and in-house custom-developed code overnight, an IDC report1 projects that 10 percent of the market for enterprise software will migrate to a pure software-as-a-service model by 2009. Our analyses suggest that software as a service is a growing priority for CIOs and venture capital investors.

Our review of venture capital investments shows that companies whose main business is delivering software as a service saw their revenues rise from $295 million in 2002 to $485 million in 2005, an 18 percent increase. On the buyer’s side, our fall 2006 survey of senior IT executives indicated a dramatic jump in the number of companies considering software-as-a-service applications during 2007.2

With software as a service, a customer contracts to use an application, such as ERP or CRM, hosted by a third party, rather than buying a software license and installing the application on its own machines. Just as consumers can check e-mail or use mapping programs with their Web browsers, so too can enterprise customers access business applications over the Internet.

Several factors are spurring the growth. New software design and delivery models allow many more instances of an application to run at once in a common environment, so providers can now share one application cost effectively across hundreds of companies—a vast improvement on the old client-server model. Bandwidth costs continue to drop, making it affordable for companies to purchase the level of connectivity that allows online applications to perform gracefully. Perhaps most important, many customers are eager for the shift, as they’re frustrated by the traditional cycle of buying a software license, paying for a maintenance contract, and then having to go through time-consuming and expensive upgrades. Many customers believe they would have more control over the relationship if they simply paid monthly fees that could be switched to another vendor if the first failed to perform (see sidebar “How CIOs can get maximum value from software as a service”). And finally, the successes of early leaders, such as salesforce.com and WebEx, have demonstrated the viability and value proposition of this model.

Market indicators suggest that investors share the enthusiasm of vendors and CIOs. Our index of companies whose main business is software delivered as a service3 outperformed the overall software company index (excluding Microsoft) by more than 13 percent from January 2002 to December 2006.

Although software-as-a-service vendors are less profitable than some traditional software vendors today, this gap is primarily caused by a lack of scale. We expect the economics of online delivery to change as the model gains wider acceptance. Large software companies (excluding Microsoft) typically have operating margins of around 25 percent. However, the margins of companies with revenues below $1.2 billion a year hover around 14 percent—close to the 13 percent margin of the average software-as-a-service vendor (Exhibit 1). A few service vendors already have much higher margins (WebEx, at 26 percent, and Digital Insight, at 19 percent) because they’ve been able to achieve scale and a leading position in their niches. Other leaders, such as salesforce.com (which provides on-demand CRM and sales force automation tools) and ADP (the world’s largest automated check processor) have also gained mainstream uptake among midsize and large companies.

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