SAP’s fourth quarter miss last week has generated lots of discussion. BusinessWeek talks of “weaker-than-expected software license sales” as well as currency exchange issues. However, the total story emerges only when you consider Oracle’s results as well. Jason Woods, in his insightful analysis of Oracle’s results, reveals that there has been a major deceleration in Oracle’s software license growth even while its services revenue grew 41% YOY. When you look at both the results, you can piece together two common themes…
- Large enterprise market is getting saturated (no surprise here). This is putting a premium on expansion into new markets lower down the food-chain. But the new set of mid-sized and smaller customers need a different product architecture, business model and mindset which SAP and Oracle are not (yet) geared to deliver. [Jeff Nolan makes this case here.]
- A license price war is breaking out that’s likely to intensify. Going by history, eventually, the new licenses will be priced lower than their cost of sales. The customer transaction will still be profitable as the initial sales revenue is only a small part of the total customer revenue stream. But this means that the maintenance revenue share will grow further. As that happens, the Oracle and SAP business models will increasingly look similar to Red Hat. [Frank Scavo points to this aggressive discounting and how this has resulted in Lawson reporting a quarterly loss.]
This dynamic – market saturation, price war, intensified desire of market expansion - which we are seeing in the ERP market has played out in other markets earlier. Take the example of the carrier telephone switch market. Like an ERP solution, the carrier telephone switch is mission critical, has high customer lock-in, requires maintenance support and needs a stream of upgrades. Some years back when the landline tele-density peaked, the switch vendors’ ended being in a price war. In fact, in many cases, Lucent, Nortel, Alcatel, etc. started subsidizing even the initial hardware for new sales on the basis of overall profitability from maintenance and upgrade revenues. Not surprising, they also began fretting about market expansion.
This fading-edge dynamic that is associated with market saturation is very different from the leading-edge dynamic that I talked about a few days ago. The leading-edge dynamic spawns successful startups. In contrast, my contention is that the fading-edge dynamic tends to be toxic to one set of players who get caught up in its vortex.
Fading-edge drives acquisitions
Now it’s understandable that the firms facing market saturation will be keen on market expansion. But this turns out to be a case of the spirit being willing but the flesh being weak. Despite their huge clout, these maturing firms have fairly atrophied capacity to accomplish market expansion by organic means (for reasons that I’ll explain in a minute). So they rely on acquisitions. The firms that they target - players in the smaller, growing, adjacent markets - find it very hard to resist the overtures. And understandably so. Not only are the big firms willing to pay big money, they also tout their big customer base and sales muscle as a bait.
It’s important to distinguish the market expansion deals from market consolidation deals. For instance, Oracle’s acquisition of iFlex – a mid-market financial applications vendor – was about market expansion into the mid-tier segment while the PeopleSoft, Siebel type of deals were about market share consolidation in the large-enterprise segment. The fading-edge dynamic triggers both these sets of deal making. Market-consolidation deals are value-creating but market-expansion deals are value-destroying.
Golden embrace turns deadly
I can hear you say that all market-expansion deals couldn’t be value-destroying. That’s too sweeping a generalization. Wouldn’t the outcome depend on merger integration, etc.? After all, hasn’t Cisco demonstrated that they market-expansion deals can be done? What’s different with the fading-edge?
It is different and here is why. As a price war builds up it drains away any profitable new license revenue. This, in turn, compromises investments in new product architectures and features. After all, in these nearly saturated mature markets, winning new customers is more about clever pricing/financing than about clever features (since the product is already “good enough”). As this throttling of new investment works its way, the budget cycle gets dominated by the maintenance and upgrade revenue perspectives. New features become more about upgrade revenues rather than new customer acquisitions killing any prospect of meaningful organic moves into new adjacent markets. In essence, the budget discipline of a mature product changes dramatically.
This new budget regime is great for mature products but is toxic for emerging products. Yet, more often than not, the new market expansion acquisitions are submitted to this new budget regime. This alone spells doom. Even when this doesn’t happen, the desire to leverage the existing go-to-market infrastructure is so strong that it pollutes the acquired business model. I have seen very few cases in the tech industry where these mistakes haven’t been made.
You’ll recollect that this is what happed to the Ascend and Bay Networks acquisitions by Lucent and Nortel respectively. I hear that this is about to happen to iFlex as well. Rumors are already flying that Oracle plans to bring iFlex in-house. This embrace would kill a promising mid-market player.
So, in summary, my view is that the next-gen ERP players focused on the SMB market better watch out. Oracle and SAP would be putting on their charm offensive for them. But it’s best for them to stay away. Do chime in especially if you disagree.
So Sharad:
The logical question that follows your blog is:
Is there a role for startups at the fading edge?
Cheers,
Tejbir