Software Industry Shows Signs of Middle Age

By John Pallatto  |  Posted 2005-12-14

Software Industry Shows Signs of Middle Age

SAN FRANCISCO—The software industry is steadily maturing and will soon start to act closer to its age by using debt to fund future expansion and development, rather than equity, which has long been the standard industry practice.

This is the view of David Roux, co-founder and managing director of corporate investment firm Silver Lake Partners of Menlo Park, Calif., who spoke here Wednesday at the Red Herring fall conference on small capitalization technology companies.

Roux said his view is that small startup companies have to rapidly grow beyond $100 million if they are going to have a good chance of making money. Most companies that earn $100 million or less tend to lose money, he said.

Furthermore, the days when the software industry as a whole grew at 20 to 30 percent per year ended with the 2000 tech industry crash and will never return, Roux said.

Instead, industry growth will be in the middle to high single digits, he said, which is more in line with other mature segments of the computer industry such as storage and semiconductors.

The reason for this is a "dirty little secret of the software business" and that is that the average selling price of software products has declined every year since 2005, he said, adding that software companies dont report their total units sold because if they did it would show "pervasive price declines" all across the industry.

Read more here about why venture capitalists are paying attention to security and data integration technology.

At the same time, there has been a return to profit growth since the 2000 crash. In fact, the great irony is that while the technology sector "experienced a depression much worse" than the nation as a whole experienced during the Great Depression of the 1930s, "software industry profits never went negative," he said.

The software industry has returned to growth and profitability because of strong cost-saving measures, which has occurred because of a return to scalable business models due to "economies of scope," Roux said. Software companies are being much more realistic about what their business models can achieve, he said.

While profit margins have recovered, only the largest companies, ones that generate more than $5 billion in annual revenue, sustain profit margins greater than 30 percent.

Ariba follows the on-demand trend. Read more here.

Companies that generate annual revenue of $1 billion to $5 billion in annual revenue drop down to profit margins of around 17 percent. Midsize companies that are producing revenue of $100 million to $1 billion can sustain 9 percent margins. But companies that cant quickly grow beyond the $100 million level are generally losing money.

The conclusion is that "bigger is wildly better" for anybody trying to compete in the software business, he said. The question for any CEO of a small to midsize software company that wants to survive and prosper is "how am I going to get to be a $5 billion business or bigger."

These factors are behind the consolidation that is going on in the software industry, Roux said. He said the market share of the top three software vendors, Microsoft Corp., Oracle Corp. and SAP AG, has increased from 24 to 30 percent just in the past five years.

Next Page: Salesforce.coms dissenting voice.


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The Oracle-PeopleSoft Inc. buyout was "a watershed event" because it signaled an even greater concentration of market share in the industry, Roux said, taking place at a time when software companies are competing for a smaller portion of IT budget dollars.

Four years ago corporate IT departments devoted 65 percent of their budgets to maintenance of existing systems and 35 percent to acquiring new technology, he said.

Today maintenance spending has increased to 75 percent and new acquisitions are down to 25 percent. This means it will be harder than ever for small companies to win a share of this business, he said.

A prominent dissenter to this view Wednesday was CEO Marc Benioff, who states his own view whenever possible that the likes of Microsoft, Oracle and SAP are going to see their growth and profits eroded by vigorous and nimble on-demand application service providers like his own hosted CRM (customer relationship management) business.

Benioff includes Google Inc., eBay Inc. and Yahoo Inc. in the category of on-demand service providers that pose critical competitive challenges to the established enterprise software companies.

Benioffs mantra is that "software is dead" and that both business IT managers and consumers will increasingly turn to software applications running on the Internet to rather than installing software packages on desktop computers or servers.

Furthermore, applications that are considered the unassailable province of Microsoft, such as spreadsheets, e-mail and even word processing, will increasingly be replaced by services running on the Web, he said at the conference.

New companies such as Zimbra Inc., which offers on on-demand, open-source enterprise messaging and collaboration systems, or, an online collaborative document management service, offer new challenges to the Microsoft Office package, Benioff said.

Click here to read more about why Microsoft plans to move aggressively into the field of on-demand software services.

It is only a matter of time, Benioff said, before an even great range of ERP (enterprise resource planning) applications are offered on the Internet.

Moves by Microsoft, Oracle and SAP to offer hosted versions of some of their applications will be too little, too late, he said, because history has already shown that hybrid strategies dont work, since these companies have too much money and effort committed to supporting their packaged software businesses.

However Roux says these trends are good for his companys business as a software industry investor. Silver Lake Partners doesnt invest in startup companies. Instead, it buys and invests in larger established companies that need money for expansion and development or are trying to recover from business or management difficulties, he said.

Roux said he believes that his firms services will become more important to the software industry when the industry begins, like mature industries, to use debt to fund growth rather than equity.

Equity has fueled software industry growth because so many investors, not just the friends and family of industry executives, have had enough faith in startups growth potential that they were willing to risk their own money to support it.

However, the software industry carries only 8 percent of its funding in debt, while the rest is equity. In the pharmaceutical industry the debt level is 32 percent. But the average among the companies in the Standard & Poors 500 Index is 152 percent debt to equity ratio.

This means that software companies have a huge untapped source of credit that they could use to fund future growth, and Roux said he is convinced that software companies will steadily increase their use of debt to fund growth as the industry continues to mature.

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