Software: Maintenance Revenue: High Margin or High Risk?

Excellent analysis today from Cowen and Co. analyst Peter Goldmacher. I can't find it posted on their site (got it via e-mail), so I'm including the key extract below for those who might be interested. Enjoy!

Software: Maintenance Revenue: High Margin or High Risk?

Consensus View: Applications maintenance, fees for technical support and product update rights, is a $20B annual business with 80%+ margins. Maintenance revenue, which is approximately 50% of total sales for most apps vendors (Oracle, SAP, Lawson and Epicor), is a highly reliable, high margin, recurring revenue stream that provides earnings stability and enables margin expansion even if license sales falter. Companies with a high proportion of maintenance revenue should sell at premium PEs.

• Our View: We believe that application software vendor maintenance fees are at risk. Our research indicates that companies continue to tighten their belts around IT spending, and ERP upgrades are not a priority. This is not a macro issue that we expect to diminish as the economy strengthens. We believe ERP upgrades, the primary motivation to pay maintenance fees, are on the wane because it's a mature market. Vendor investments in R&D are on the decline, innovation is lagging and redeployment costs are multiples of the license fee. As a result, customers are increasingly questioning the value of paying annual maintenance fees of 20% of the cost of the original license for the occasional use of technical support. We believe that as the value proposition around maintenance fees diminishes, there is significant opportunity for third party service providers to offer low cost tech support. While there are only a small number of these third party providers today, we believe that as Apps sales continue to decline, there is a significant over capacity of consultants with ERP expertise looking for opportunities to leverage their skills. We believe these dynamics will result in the creation of a number of businesses designed to chip away at the exorbitant revenues and margins associated with vendor maintenance fees.

Valuations and financials of SaaS vs. traditional enterprise software vendors

Interesting, thoughtful analysis from John Keenan ...

I track the performance of the publicly-traded SaaS vendors and thought you might find it interesting. With the recent IPO of LogMeIn, there are 28 pure-plays. I track the financial performance for the company's last fiscal year and valuation performance on a quarterly basis (I use month ends of February, May, August and November).

Re: the financial performance, the story is growth and cash flow. For the last fiscal year, the SaaS vendors grew 31%, with on-demand revenue up 39%. I also track the 146 publicly-traded software vendors and their figures are total revenue up 16% and license revenue down 6.8% (all their growth is in maintenance and PS). It is clear that users are shifting their spend away from legacy perpetual models to SaaS models.

The 28 SaaS vendors averaged $160M in total revenue (14 were over $100M) and had an average operating loss of ($6.8M) - only 8 the vendors were profitable. However, their free cash flow was very strong and averaged $14.6M - 21 of the vendors were cash flow positive.

Spending on sales & marketing, R&D and G&A averaged 36.5%, 12.9% and 16.5% of revenue respectively.

Finally, while valuations have recovered in the past 6 months - interesting, the aggregate market cap for the 28 vendors is up about 29 % in each of the last 2 quarters - they are down 10% from August 2008 and 26% from the market's peak in October 2007.

Probably the most notable change is the reduction in valuations as a percentage of revenue. In August 2008, the valuations were about 6.1X trailing-twelve-months (TTM) revenue. As of August 2009, it's about 4.2X TTM revenue. In October 2007, it was over 10X TTM revenue.

If you want to follow up on this with the author, please comment here or send him a message to jkeenan with the domain name impacsus.com.

SAP CTO Vishal Sikka named "Corporate Officer"

Vishal Sikka, SAP's CTO, was named a "Corporate Officer" by the SAP Supervisory Board. This is like getting "tenure" in an academic environment, and signals a significant increase in his authority, as well as a recognition of his accomplishments. Vishal really created the centralized architecture function at SAP, and has been very influential in all product groups at SAP. He is the first CTO in SAP's history, and the first person of Indian ethnicity to be appointed to a corporate officer role at SAP (as far as I know). This also creates a very real possibility that Vishal will be appointed to SAP's Supervisory Board (like the Board of Directors in American companies) in the future.

Congratulations to Vishal! The internal announcement follows:

Dear Colleagues,

I have the pleasure of announcing that the SAP Supervisory Board named Vishal Sikka an SAP Corporate Officer and a member of the SAP Executive Council at the end of July.
This appointment recognizes Vishal's contribution in forming the Office of the Chief Technology Officer (oCTO) as a unit that provides technical leadership to the company and thereby helps SAP secure a competitive advantage in the field of enterprise solutions.

In addition, his appointment recognizes both the role that Vishal has personally played and will continue to play in architecting SAP offerings into Timeless Software, and as a key spokesperson representing SAP as a technology thought leader, both internally and externally.

Vishal will continue to serve as SAP’s Chief Technology Officer (CTO) and report to me.
Prior to becoming the CTO of SAP in 2007, Vishal was the senior vice president of architecture and chief software architect at SAP, responsible for the road map and direction for the architecture of SAP's products and infrastructure. Before that, he was head of the advanced technology group responsible for strategic innovative projects.

Vishal holds a doctoral degree in computer science from Stanford University in California, and his experience includes research in automatic programming, information and application integration, and artificial intelligence at Stanford, at Xerox Labs in Palo Alto, and at two startup companies.

Please join me in congratulating Vishal!

Best regards,
Léo