SAAS Route Could Be Bumpy

Capital spending needs threaten to derail growth.

Selling software was once such an easy job. Since most of your costs were associated with creating your first copy of the software, you knew that if you had even a moderately successful product, you could make a lot of money, as every subsequent copy would cost only pennies but would be sold for dollars. Companies that got the formula correct—Microsoft comes immediately to mind—enjoyed revenues and profit margins that were the envy of the entire business world.

But, as President Marc Benioff likes to remind us, software is dead, and SAAS (software as a service) has taken over. Software vendors are now selling a service and offering an application platform to customers that are being asked to license a service, rent an application and pay a maintenance fee for the service on their contract.

However, one issue is rearing its head as an obstacle between SAAS nirvana and the types of growth in revenues and margins once enjoyed by companies that developed an operating system or application and sold the packaged application for installation by the customer. That issue is capital spending, and it is just starting to pop up in the financial statements of technology vendors.

In particular, both Google and Microsoft are on capital spending programs totaling billions of dollars. In 2006, one analyst noted that Googles capital spending had reached an estimated $1.8 billion ( Not to be outdone by Google, Microsoft is intent on building data centers that will dwarf even those huge centers Google is constructing. According to Reuters, Microsoft on April 16 was due to switch on a massive data center in Quincy, Wash., that is the size of seven soccer fields, and a $550 million Microsoft data center is already under construction in San Antonio.

Switching from a business where you spent millions to create applications that, once developed, could be copied and sold for pennies to a business where you are responsible for not only creating the application but also providing the IT infrastructure to run the application is a major shift. And, like any major shift, there will be some unintended consequences. What consequences? I think youll see the following as vendors shift from being software sellers to infrastructure providers.

First, there will be a continuing quest for efficiency and added services. If you, as a SAAS company CEO, are going to cough up a couple of billion dollars for server farms the size of many soccer fields, you want to get those servers running at full capacity to recoup your investment. Full capacity means lots of new customers and lots of new services to sell to current customers.

Having lots of new customers defines Microsofts future as a service provider as overseen by Ray Ozzie. Lots of new services range from Google figuring it can provide video on demand that rivals broadcast networks to Salesforce.coms drive to add new applications (oops, sorry, lets call them business services) on top of its existing platform. And dont forget that Yahoo, and telecommunications carriers are also making capital investments to capture new customers and add new services.

The second consequence is the capital investment hangover. Financial analysts have no patience and will not look favorably on big capital investments that do not drive immediate service revenues. Technology executives will have to learn what steel mill executives discovered long ago: Capital investment is not a one-time event. That server farm you built last year will soon require another big round of investment to stay current and efficient.

For the customer looking at a SAAS provider, all this will mean a new question in the request for proposal. In addition to understanding a vendors strategic product direction, you will want to know the vendors capital spending plans and how those plans will provide you with the service you expect at a cost the vendor can provide—without starving future products to keep the server farm up-to-date.