The Bottom Line on SaaS
As vendors scramble to provide on-demand offerings, an in-depth analysis of the numbers behind one SaaS business show a superior economic model.
By Scott Bolick, George Gilbert and Rahul Sood, Tech Strategy Partners
Jul. 06, 2006
Software-as-a-Service (SaaS) is a top-of-mind consideration for most software company leaders today. The idea is hot but the reality is challenging (as Ray Lane wrote earlier this year ) leaving many vendors on the sidelines. Although there are several intuitive arguments in favor of the model, there is still disagreement on how and why the SaaS model is superior to the traditional perpetual licensing model.
Few thorough analyses are available on the long-term impact of the SaaS business model. After a careful examination, it was determined that the best way to delve into the strength of the SaaS economic model would be to use SalesForce.com's (SFDC) quarterly figures and analyze them to uncover the company's true profitability.
The numbers told a compelling story: SaaS is not just a superior economic model, but it also has several strategic advantages over the traditional licensing model. Normalizing SFDC's income statement expands operating margins to an implied 33 to 39 percent, up from a currently reported 6 percent. SaaS is economically more efficient for the customers too, as it minimizes their spending on IT infrastructure and services. SaaS also allows vendors to shrink their product innovation cycles and drive innovation across a wider cross section of their customers than the traditional model.
A Closer Look: Normalizing the SaaS Model
Most vendors agree: the biggest advantage of the SaaS model is its insulation from large, lumpy sales deals and the better predictability of the annuity revenue stream. Another big advantage is the resilience of the model vis-à-vis changes in the capital spending of customers, since customers can account for their spending as operational expense.
On the negative side, there are concerns over several aspects of the business model, especially since the leading SaaS vendors have profitability of 3 to 6 percent as opposed to traditional vendors who earn 25 to 35 percent of their revenues as operating profits.
But there are a few reasons for this discrepancy. First, revenue growth is slower at SaaS companies because it is no longer front-loaded by perpetual licenses. Second, gross margins are perceived to be low because SaaS is compared to legacy ASP models which have to factor in the costs associated with the customer- "silo"-ed data center required for application hosting and service delivery. Finally, sales and marketing costs remain persistently high as generally acceptable accounting principles (GAAP) force recognition of expenses in advance of subscription revenue, as well as the continual requirement to replace churning customers.
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Few thorough analyses are available on the long-term impact of the SaaS business model. After a careful examination, it was determined that the best way to delve into the strength of the SaaS economic model would be to use SalesForce.com's (SFDC) quarterly figures and analyze them to uncover the company's true profitability.
The numbers told a compelling story: SaaS is not just a superior economic model, but it also has several strategic advantages over the traditional licensing model. Normalizing SFDC's income statement expands operating margins to an implied 33 to 39 percent, up from a currently reported 6 percent. SaaS is economically more efficient for the customers too, as it minimizes their spending on IT infrastructure and services. SaaS also allows vendors to shrink their product innovation cycles and drive innovation across a wider cross section of their customers than the traditional model.
A Closer Look: Normalizing the SaaS Model
Most vendors agree: the biggest advantage of the SaaS model is its insulation from large, lumpy sales deals and the better predictability of the annuity revenue stream. Another big advantage is the resilience of the model vis-à-vis changes in the capital spending of customers, since customers can account for their spending as operational expense.
On the negative side, there are concerns over several aspects of the business model, especially since the leading SaaS vendors have profitability of 3 to 6 percent as opposed to traditional vendors who earn 25 to 35 percent of their revenues as operating profits.
But there are a few reasons for this discrepancy. First, revenue growth is slower at SaaS companies because it is no longer front-loaded by perpetual licenses. Second, gross margins are perceived to be low because SaaS is compared to legacy ASP models which have to factor in the costs associated with the customer- "silo"-ed data center required for application hosting and service delivery. Finally, sales and marketing costs remain persistently high as generally acceptable accounting principles (GAAP) force recognition of expenses in advance of subscription revenue, as well as the continual requirement to replace churning customers.
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