CONFERENCES

Enterprise ’98: Report

Preface

We are very pleased to provide you with the premiere issue of our annual report on the state of the Enterprise Solutions industry. The first such event of its kind, Enterprise 98 significantly surpassed our expectations in terms of both the quality of the discussions and the number and caliber of participants. We were honored to host leaders from over 80 organizations in a setting where ideas flowed freely, debates were fruitful, and interaction with peers was a must.

In this report, we hope to have captured the thoughts and perspectives of visionaries that have looked beyond the near term horizon and identified what are the trends, challenges and opportunities in one of the most dynamic sectors of the technology landscape. The report is organized into two parts. In Part One, we synthesize some of the key insights from the Quick Tally instant surveys conducted throughout the conference. In Part Two, the conference organizers, Sand Hill Group, have asked McKinsey and Company to elaborate on the insights from McKinsey's closing session and provide some thoughtful perspectives summarizing the state and direction of the industry.

We hope you enjoy reading this report as much as we enjoyed the conference. We also hope that the report will further the discussions around the many key issues and opportunities that the industry faces.

We look forward to seeing you at Enterprise 99!

Introduction

Enterprise 98, a senior management-level conference focused on enterprise solutions, was held in Carmel, California from June 7-9, 1998. Organized by the Sand Hill Group LLC, Enterprise 98 brought together a "Who's Who" of the enterprise solutions space: senior executives from many of the leading vendors, high-profile entrepreneurs, venture capitalists, investment bankers, and consultants. The conference provided a unique opportunity for these industry sector leaders, in a private and intimate setting, to share their perspectives and debate key strategic issues and trends facing the enterprise space.

This report is intended to both summarize the conference and to provoke further thought among its participants. The first of its two sections contains key insights from the conference, including the results of numerous real-time surveys conducted during the proceedings. The second section builds on the concluding address of the conference delivered by McKinsey directors Bill Pade and Mike Nevens, and is included here at the conference organizers' request. This section examines the current state of the enterprise software industry, proposes key challenges for the industry going forward, and looks at strategic options for big vendors and smaller "best of breed" players as the enterprise software delivery system is restructured.

Profile of Participants

Enterprise 98 brought together the leaders of the enterprise software industry. The 81 participants represented three different segments of the industry: Software (69% of the audience), Services (15%), and Investment Banking/Venture Capital (16%). Nine out of ten participants were either CEOs or partners of their respective companies.

The attendees demonstrated the breadth of opportunities in the enterprise space: on the one hand were 30 public companies with a combined market capitalization of over $90 billion; on the other were 40 emerging companies each with under $100 million in annual revenues and fewer than 500 employees. Large or small, nearly three-quarters of these attendees expect to grow their revenues more than 50 percent in the next 12 months. Of the private companies represented, over 20 indicated plans to conduct an Initial Public Offering in the next 12 months.

Key Issues and Beliefs

Real-time surveys of attendees regarding key industry issues were an integral part of the conference. Six essential issues and beliefs emerged from these surveys. Three of them focused on the forces changing the industry; two others related to the opportunities and limits to growth facing vendors of enterprise solutions; and the final belief focused on growth strategies:

• The Internet is not expected to significantly change the structure of the enterprise software industry during the next 5 years
• The backend ERP space (financials, accounting, HR, etc.) will consolidate, but the "front office" space (sales force automation, customer information solutions, marketing automation, etc.) will remain fragmented
• Significant uncertainty in the industry surrounds the role of newly entering content providers (such as Yahoo!) and service outsourcers (such as Federal Express)
• Services are perceived to be the industry's largest growth opportunity, provided the industry can deliver solutions effectively and efficiently.
• Companies are waging a "war for talent" that may ultimately constrain industry growth.
• Emerging players are banking on a "best of breed" positioning as their path to success and count on the financial markets' continued support for vendors pursuing this strategy

Forces changing industry structure

The Internet will not change industry structure

Surprisingly, most players do not believe the Internet will change the structure of the enterprise software industry during the next 5 years. They hold this belief for two reasons. First, participants believe that extra-enterprise users (over the Internet) will have limited revenue potential and marginal effect on the industry's current licensing/pricing model. Second, they believe that most users will access enterprise software primarily through Intranets, not the Internet.

Some 56% of respondents believe the Internet will not change the balance of power in the industry over the next 5 years [Exhibit 1]. In order to change the balance of power, the Internet would have to become the primary vehicle for accessing enterprise software, particularly to extra-enterprise users - for example, through applications service bureaus. Yet 81% of participants believe extra-enterprise users will have minimal or no impact on the industry's current licensing/pricing model, and most participants (69%) believe these users will contribute at most 30% of enterprise software revenues over the next 2 years. At the same time, half the participants believe the increased penetration of the enterprise through light/browser users will be done by leveraging internal Intranet infrastructure, rather than through the external Internet.

The Internet might also impact the industry by creating more efficient software delivery models, increasing the availability of modular components, providing cross-enterprise connectivity for supply-chain solutions, enhancing Web-based customer interaction, etc. But Enterprise 98 attendees remain skeptical that these will substantially change how the industry interacts or alter the balance of power between incumbents and newcomers.

Consolidated ERP, but fragmented Front Office

Enterprise 98 participants seem to be in violent agreement when it comes to future industry composition [Exhibit 2]. Participants expect the providers of backend ERP software - such as financial and accounting applications, human resource applications, etc. - to consolidate within the next five years. Front Office suppliers, on the other hand, will remain fragmented. Almost half of the respondents believe 3 or less companies will control 80% of the ERP market share by 2003. In particular, all participants from services companies expect this to be the case, whereas software vendors were divided in their opinions. In contrast, the majority of participants believe Front Office will remain relatively fragmented, with a large number of competing providers developing customer management, sales force automation and other applications.

Uncertainty surrounding new entrants

Plenty of uncertainty surrounds the roles and likelihood of success for new entrants in both enterprise software and services. This year's participants felt Yahoo! is a credible contender, Microsoft is a desirable and relatively harmless new entrant, and FedEx (and other outsourcers) are not a threat to software vendors.

Two thirds of the participants believe that Yahoo! and other service content providers are contenders in the enterprise software space. The role envisioned for Yahoo! would be, for example, as a web-based service provider, charging for services on a "pay-as-you-go" basis.

In contrast to the view held in most industries, the majority of attendees believe the entry of Microsoft into the enterprise space is positive for the industry overall. Although they do not think Microsoft (in alliance with SAP) will be dominant in terms of concentrating value or setting object standards, they feel that having reduced uncertainty about future platforms (e.g., WinXX desktop and WinNT servers) helps their own development and implementation plans. This group didn't perceive Microsoft as a threat to their own business.

FedEx has established a complete infrastructure to handle distribution and supply chain functions as an outsourcer. When asked whether this model of a dominant player in another sector leveraging their competencies in the enterprise solutions space would be successful, the majority of software vendors (80%) responded "no." However, service vendors hold a different view; most (60%) believe FedEx (or similar players) will become dominant over time, as they leverage existing infrastructure, skills, and resources.

Growth opportunities and challenges

Services will grow in importance - if barriers are overcome

The attendees strongly stated their opinion that services - consulting, implementation, maintenance, support, outsourcing, etc. - represent the largest future revenue opportunity in the industry. Eighty five percent of attendees believe services will capture the largest share of revenues in the industry five years from now. In particular, participants believe the greatest opportunities lie in total turnkey solutions and applications rental (service bureau). Applications operations (outsourcing) are seen as a secondary opportunity.

Participants raised two significant issues around the ability to deliver solutions effectively and efficiently: The first is that software implementations may become the bottleneck to the growth of the industry. There was almost unanimous agreement (95%) that the current level of services required to install and operate enterprise software is out of control. Moreover, most participants believe the majority of licenses they have sold have not yet been deployed. This problem is particularly acute for high growth companies, half of which asserted that the majority of their licenses remain dormant.

The second issue is the tension between service and software vendors over account control [Exhibit 3]. Even though most respondents stated that the influential general contractor role will remain in the hands of service companies (such as Big 5, or regional system integrators) the software vendors believe they need to provide services to obtain account control. In fact, most (70%) vendors expect that services will account for at least 30% of their revenues in the year 2000 [Exhibit 4].

The war for talent

Enterprise 98 participants rated employee hiring and retention as the most important issue facing companies in the industry [Exhibit 5]. Companies have been struggling to staff and maintain their development and consulting organizations due to both demand and supply issues.

As companies are growing at double-digit rates, they're placing significantly higher demand on the engineering and computer science talent marketplace. New graduates with limited work experience are considered hot commodities if they've taken a single Java programming class. On the supply side, schools and universities are producing a reasonably constant number of graduates, and certainly not growing 20% annually or higher. This deficit has raised the value and the mobility of key (and even not-so-key) personnel, and has increased compensation and benefits to levels never seen before. These pressures are straining the cash-strapped smaller companies and stretching the generosity of cash-rich companies. More importantly, in many cases these factors are delaying product deliveries, thus allowing competitors, who may be slightly richer in talent, to reach the market first.

Strategies for Growth

Emerging players bank on best of breed

Emerging players are banking on a "best of breed" product strategy to create a distinctive offering and differentiate their product vis-y´-vis their competitors. In following this approach, vendors focus on specific functional or content areas and develop a unique product offering that integrates with traditional backend systems, such as the ERP "backbone."

A "best of breed" position appears to be desirable to companies considering an IPO. Survey results indicate that the majority (77%) of private companies are positioned as "best of breed," whereas public companies are evenly split between "integrated suite" (53%) and "best of breed" (47%) vendors. The survey also indicates that respondents view the challenge of carving a "best of breed" or "integrated suite" position as the most important issue facing most (62%) pre-IPO companies.

Most small and medium vendors believe "best of breed" players - in other words, themselves in most cases - can grow to a dominant position in the industry. The vast majority (91%) of players with less than 1,000 employees believe this to be the case. Larger companies agree, but are somewhat more skeptical.

The Current State of the Enterprise Software Industry

The history of the information technology industry can be characterized by a series of "waves" that have driven growth and the emergence of new players. The first, mainframe-centric wave was dominated by a few companies like IBM, Burroughs, and DEC. Client-server computing created the second wave and resulted in a push towards open standards, as well as the appearance of many new companies on the landscape, such as Compaq, Microsoft, Oracle, and Sun. The industry is now experiencing a third wave of growth, driven by inter-networked, enterprise-wide IT [Exhibit 6] solutions. In this phase, companies like Andersen Consulting, Peoplesoft, and SAP are acquiring significant market and mind share in corporate data centers and board rooms.

In this 3rd growth wave, two distinct playing fields in the Software & Services sector have emerged [Exhibit 7]: in the first grouping, a high margin, low profit/seat, standards-based, and concentrated market has evolved in the lower parts of the "IT stack." In this market, Microsoft dominates in the operating systems sector with its Windows9X desktops and its rapidly growing NT servers, while Oracle dominates the database sector with high market share in most large corporate accounts. Many observers view Microsoft as the strongest contender to threaten Oracle's superiority, especially at the mid- and low-end, with its SQL Server offering on Windows NT.

In the upper elements of the stack - enterprise applications and services - a high margin, high price/seat, less concentrated market has emerged.

Here a handful of major players and a proliferation of emerging players vie for customer visibility and market share. The discussions at Enterprise 98 were mostly focused around this segment of the market.

A coming consolidation?

A huge installed base of IT, access to capital and increasingly open standards and platforms (Wintel, TCP/IP, Unix, SQL) have created opportunities for emerging players that can leverage the installed IT infrastructure. For example, PeopleSoft has grown to a billion-dollar company in less than 9 years since releasing its first HR application.

This increase in the number of rapidly growing entrants to the industry has resulted in decreased revenue concentration among the top technology companies worldwide: The top 10 companies accounted for 49% of worldwide IT revenues in 1991. With some changes to the composition of the "top 10," this group accounted for only 39% of total revenues in 1996 [Exhibit 8]. The positive environment for emerging players is reflected in the view of small company participants in Enterprise 98, most of whom have aspects of a "best of breed" approach in their core business strategies. However, most conference participants believe the industry will see greater consolidation over the next 5-7 years, at least in the ERP space.

This view is supported by the huge revenue expectations for the key industry players. Capital market expectations for a selection of the largest players1 imply that these companies will need to generate, in aggregate, worldwide revenues of almost $1.3 trillion by 2007, or grow about 18% yearly [Exhibit 9]. These growth expectations may be justified if one considers the value creation potential of IT in terms of reducing the cost of interactions. In the US economy alone IT could produce $1 trillion in productivity gains per year, according to a recent McKinsey & Company study.2

One approach that some of the leading vendors are taking to meet their growth targets is to expand their activities in new areas of the "IT stack" [Exhibit 10]. Through mergers, acquisitions and organic growth, these companies have indicated they'll provide a broader set of products and services to their customer base.

Challenges Facing The Industry

Inefficient delivery system for enterprise software

One of the key barriers to this projected growth in the industry is the highly inefficient software delivery system. Exhibit 11 shows that the delivery system multiplies the delivered cost of software by up to 20 times its actual intellectual capital content (defined as unit cost of R&D per seat). Systems integration and implementation services are the main cost category in this delivery system. It's not unusual to hear of companies running up tens or even hundreds of millions of dollars in extra costs and schedule delays.

Although most Enterprise 98 attendees recognized the inefficiency of software implementations as one their key concerns, they still see services growing dramatically, relative to software revenues. This seemingly paradoxical position leads to a conclusion that many vendors may not be adequately focusing on the competitive benefit that would be gained from substantially reducing the high services-to-license ratio that is characteristic of most applications in the enterprise space.

The Internet promises to provide a platform for more efficient delivery of software, and even some services, to the enterprise. Surprisingly, most Enterprise 98 participants do not believe the Internet will have a significant impact on industry structure over the next 5 years. Yet there is emerging evidence of the Internet's impact on software business models in which some leading-edge enterprise IT companies are developing alternative solutions leveraging the Net:

• New product offerings for the low- and mid-tier market that rely on Internet-based marketing, sales and delivery, and browser-based thin client interfaces
• Componentized software design, which reduces the complexity of modifications and enhancements to customer solutions
• Disintermediation of traditional channels through Web-based sales and delivery of upgrades and new modules
• Web-based customer service, consulting and training, which significantly reduces the cost of services
• Service bureaus offering rental of applications on an as-needed basis

Customers are increasingly questioning the value/cost equation from IT

As a result of this inefficient delivery system, and other factors, enterprise customers do not gain full economic or competitive value from their increasing investment in IT. Although many of them have embarked on long-term implementation cycles of enterprise-wide solutions, few are confident that the actual return on their IT investment - from a full business system perspective - will be attractive.

According to surveys conducted by McKinsey, today's top of mind issues for CIO's are dominated by four topics (Exhibit 12):

• How to reduce complexity in their IT architecture (for example, deciding between best-of-breed and integrated solutions, standards, computing and communications capacity, etc.)
• Reducing solutions implementation time and overall implementation cost, and what is the ideal software upgrade model
• More creative, risk-sharing pricing arrangements with suppliers
• Consolidating the number of their vendor relationships (e.g., how many vendors do they want to deal with for a specific project, and who should play the "general contractor" role). This consolidation orientation is primarily driven by economics, and in distinct conflict with their "best of breed" preference.

Of these four key topics, only the first one reflects a technology-related issue. The other three are clearly related to the delivery system, and indicate how substantial the impact of a more efficient system could be: it would allow vendors to capture the real demand for IT and deliver the true business value it promises.

War for talent could constrain industry growth

Companies in the technology arena are clearly dependent on the ability of their employees, from R&D to customer support, to deliver increasingly sophisticated intellectual capital. Companies will live or die based on their ability to attract, reward and retain highly distinctive technical and management talent. As the Enterprise 98 attendees have overwhelmingly indicated, this is their key concern, and addressing it will require considerable CEO and board-level focus.

A recent McKinsey research project examining how a broad range of technology companies are responding to the "war for talent" has developed specific recommendations on how to address this issue. Companies will have to actively create a winning "employee value proposition" that meshes the company's overall identity (value system, culture, management team and philosophy) with what it offers to its employees (challenging environment, intellectual autonomy, career advancement opportunities, etc.). Companies that address their talent needs proactively and creatively will have a substantial competitive advantage over those that don't.

Restructuring The Delivery System

As customers begin to demand a simplified enterprise IT delivery system - and in order to remove the biggest barrier to their own continued growth - key enterprise IT vendors have started to restructure the way they deliver enterprise IT systems to their. This process involves both vertical and horizontal "rationalization." This much-needed overhaul will be likely to unlock demand for enterprise software and create a further revenue boom in the industry. As the restructuring takes place, key industry vendors will need to rethink their strategic options as they play a central role in delivering IT, and emerging players will be able to utilize key vendors as channels to the enterprise for their "best of breed" solutions.

Vertical rationalization

The first angle of attack for key industry vendors as they attempt to simplify the delivery of enterprise IT is one of vertical rationalization. This involves:

• Building a position in at least three layers of the IT stack to lower the complexity and cost of solutions
• Using this broad positioning to gain account control in order to lower the marginal cost of incremental sales
• Leveraging the favorable economics of account control to provide a pipeline of distinctive products from multiple vendors to the customer, in order to satisfy the desire to tap into "best of breed" functionality

Two basic economic levers will enable the key vendors of enterprise software to put in motion the low price/high volume economic model that has characterized, for example, the operating systems market [Exhibit 13]:

• Reduced sales and marketing costs, through more effective use of new marketing and distribution channels such as the Internet
• Increased volume as a function of a higher effective price elasticity of demand, resulting from a lower service-to-software ratio

This rationalization will lead to a fundamentally restructured delivery system for enterprise software [Exhibit 14].

A rationalized delivery system has direct implications for emerging players: rather than building their own sales and services delivery organizations, they should structure licensing, marketing, and sales agreements with the key vendors. This will be done through strategic alliances, partnerships and joint venture arrangements.

Horizontal standardization In addition to the vertical rationalization described above, another emerging structural trend is horizontal standardization. Vendors can assume that many components of the IT infrastructure will be well-defined or quasi-standard, for example:

• TCP/IP being the dominant intra- and inter-network communications protocol
• The Win32 API being the dominant desktop solution
• Windows NT and a handful of flavors of Unix being the dominant server operating systems in the short-to-medium term
• Relational, SQL-based databases with object extensions and enhanced Web support being the typical data and transaction repository

With this predictability, R&D efficiency increases, as vendors can dedicate long-term resources to development efforts. At the enterprise software level, developers can "write" to a small set of platforms, and not run the risk of being overtaken by emerging market standards that would require significant product rearchitecture and redesign.

Strategic Initiatives For Enterprise Vendors

Enterprise vendors will have to select from a mix of initiatives to achieve their strategic aspirations. Among others, they may choose from the following approaches:

• Aggregate value and deliver it to customers: this applies mostly to established players with significant investment in their sales and marketing channels. For example, key vendors would themselves develop various elements of the stack and provide a pipeline for best of breed software from various 3rd parties. An example is Oracle's relationship with i2 and Manugistics for supply-chain management solutions.\
• Build privileged relationships: this model requires establishing, for example, exclusivity-based relationships that leverage one partner's customer base. An example is France's Dassault Systems' exclusive worldwide distribution relationship with IBM.
• Leverage distinctive intellectual property: this requires creating unique algorithms, techniques, and solutions that are significantly ahead of the competition and that can't be easily replicated. An example is i2's constraints-based algorithm in its Advanced Planning Engine.
• Leverage unique content assets: this requires building comprehensive repositories of information that are critical to customer requirements. An example is Aspect Development's universal catalog of electronic parts and components, which is extremely helpful for chip and board design.
• Build a distinctive business system: this requires creating a new delivery model that significantly redesigns existing systems or increases the "vertical" product and services offering. One example is USinternetworking's Peoplesoft-based product offering to mid-market businesses, delivering enterprise applications over a Web-based service bureau model.

Opportunities For Emerging Players

The key vendors will have significant account control, as customers' desire to reduce the number of vendor relationships continues to prevail. These vendors will, in addition, want to provide increasing breadth of products and services to meet their growth expectations. This will create distinct opportunities:

• The demand for the emerging players' value added software and services, such as a best-of-breed vertical industry solution, will increase

• Emerging players, through strategic partnerships and alliances, should exploit the key vendors as channels to the enterprise. With this leverage, sales and marketing efficiency increases, since they don't have to create or replicate a complete sales organization and can focus on what they do best: develop intellectual property.

The enterprise solutions industry has significant room to grow, with differing opportunities for large incumbents and emerging players. Ultimately, to conquer the customer and maintain a long-lasting relationship, large and small vendors and service providers will have to coexist through special relationships and partnerships. There exists a fundamental need to redesign the delivery system, to leverage the growth of the Internet, to consider the customer predicaments, and to aggressively identify and institute policies to reduce the impact of the war for talent. Their ability to grapple with these very real challenges will determine the relative success of players in the enterprise solutions space.

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