Computer hardware and software firms must choose between profit margins and revenue growth while eying new delivery models.
The tech industry is always in flux. Frequent new products and category innovation define and redefine the sector’s constantly shifting landscape. But lately we’ve seen even greater volatility than usual, and it has begun to affect the makeup of hardware and software companies themselves. Increasingly, technology firms are reexamining the structure of their businesses and taking bold steps to squeeze out better financial performance. They are doing this because their profit margins and market share are under siege from disruptive, often well-funded startups and other aggressive competitors. The competition, in turn, has made customers more demanding. They are seeking greater performance, better features, and more platform independence and flexibility at the lowest price point possible.
This volatility is manifested in a flurry of attempted
and consummated mergers, acquisitions, and divestitures. In the early fall of
2014, for example, multiple major business publications reported that
Hewlett-Packard was in talks to purchase storage equipment maker EMC, primarily
to improve scale and cut costs. Both sides refused to comment on any possible
deal, and none occurred. Then, in November, HP announced that it was splitting
in two, separating its computer and printer hardware business (HP Inc.) from
its enterprise hardware, software, and services units (Hewlett-Packard
Enterprise). HP’s goal for the split is to allow both units, which will each
generate more than US$50 billion in revenue and be Fortune 50 companies, to
become more nimble and focused on their respective markets and competitors.
With this breakup, the two companies will have to find ways to improve the
performance of slow-growth businesses struggling to maintain decent profit
margins.
Another high-profile divorce is aimed at enabling two
different but potentially high-growth units to focus on new revenue streams in
their own separate ways. EBay’s 20-year-old online auction business is
separating from PayPal, which was purchased in 2002 for $1.5 billion. Half of
PayPal’s revenue comes from eBay customer transactions, which are continuing to
expand, but at a slower pace than PayPal’s activities outside eBay. By creating
two public companies, management seeks to let PayPal accelerate revenue growth
by forming partnerships with financial-services firms, retailers, and others,
and by developing new products and services for the rapidly evolving mobile
payments ecosystem. EBay, on the other hand, will be able to turn its full attention
to revenue opportunities in its core auction and online commerce platforms by
streamlining and upgrading across multiple markets.
Meanwhile, on the acquisition front, IBM has invested
heavily in the cloud computing and big data sectors. By doing this, the company
is hoping to drive revenue growth, which, except for a few quarters, has been
sluggish since the Great Recession.
Finally, Symantec, a much smaller firm best known for its
antivirus software, is also splitting into two companies: cybersecurity and
information management with a focus on data storage. Both of these lines are in
stiffly competitive segments, and Symantec management envisions that the
separation can provide better revenue growth through the businesses’ distinct
strategies, targeted investments, and innovation.
Revenue or
margins?
These are just early examples of the kinds of ongoing
corporate reevaluations that we believe many technology companies will
undertake during the next few quarters. At the heart of each of these
restructuring, spin-off, and operating model transformation efforts is the same
fundamental question: Will focusing on revenue growth or improved margins best
deliver sustainable shareholder value? This is a critically important decision
for these companies; indeed, their future is ultimately at stake. However, an in-depth
analysis of this question produces a conclusion that greatly simplifies the
answer: namely, in the tech industry in almost all situations, widening revenue
streams is the only viable option for long-term survival. In fact,
companies that look inward toward margin improvements can maintain that
strategy for only a short time before shareholders will lose their patience and
the company will lose its support in the marketplace.
The heart of this analysis is our recent
examination of 47 technology companies using a concept called relative value of
growth (RVG). Introduced in 2005 in the Harvard Business Review, RVG
incorporates a wide array of data, including enterprise value, cash flows,
revenues, tax rate, growth rate, and earnings before interest and taxes, to
produce a ratio that compares the amount of shareholder value generated by 1
percent of revenue growth to the shareholder value generated by 1 percent of
margin improvement. An RVG of 3 means that a company would enjoy three times as
much shareholder value increase from 1 percent of revenue growth than it would
from expanding its profit margin by 1 percent; an RVG of .5 means that focusing
on revenue gains is worth half as much as driving margins higher.
Perhaps the most striking result of our
analysis is that more than 80 percent of the companies have RVGs above 1, and a
majority of these are over 3. For example, underscoring the value of revenue
growth is Facebook’s RVG of 100. But even more established tech companies like
Adobe (RVG: 16.5), Yahoo (RVG: 22.5) and Microsoft (RVG: 5) are clearly on that
side of the scale as well. For these and most other tech companies, the future
will depend not as much on cost cutting as it will on outpacing competitors in
rapidly evolving high-growth areas such as cloud computing, cybersecurity, data
analytics, everything-as-a-service (XaaS), and digital content. In other
words, their growth (and thus their shareholder value) will depend on continual
innovation. As for the planned spin-offs, our RVG analysis finds that the
strategy undertaken by both eBay (RVG: 5.1) and Symantec (RVG: 3.9) to chiefly
achieve superior growth from these split-ups, rather than enhanced margins, is
the right move.
By contrast, earnings growth has been the preferred
approach to shareholder value for many large, hardware-heavy legacy companies
in this industry. They have seen revenue stagnation and have been through years
of cost cutting to deliver stable earnings. Considering these companies’
fundamental performance data — as well as the absence of significant
revenue-generating innovation to replace lagging sales — this was, by and
large, a successful approach. In fact, hardware providers such as Lenovo,
Samsung, and Lexmark had the lowest RVGs in our study, below 1, indicating that
in their cases, shareholders would generally respond positively to sustaining
value through earnings growth.
However, this is where the data must be enriched by
observation and experience about how the tech industry is unfolding. In our
view, the vast slant in the RVG analysis toward the revenue growth side is
indicative of the overwhelming value of that approach for tech companies.
Although pursuit of profit margin gains for firms with an RVG lower than 1 may
have been an efficacious course of action in the past, we believe it is now a
troubled path. Most of these companies are facing shrinking markets for their
legacy products. Without some top-line improvement through organic innovation
or acquisition, they are in the precarious position of being just a few
earnings disappointments away from alienating shareholders, shedding market capitalization,
and potentially becoming targets of activist investors or takeovers.
HP’s spin-off decision is intriguing in this
light. Its RVG of 0.9 shows that shareholders are rewarding the company’s
efforts to slash costs, which it has done in numerous rounds over the years. In
its new two-company structure, however, HP is ambitiously hoping to pair margin
preservation with a return to revenue growth. HP Inc. will seek to further
reduce expenses in its fiercely competitive consumer PC business while hoping
to deliver much higher margins and grow revenue streams from its printer line,
a cash-cow product with plenty of room for innovation, particularly in 3D printing. Similarly, Hewlett-Packard Enterprise intends to
have a margin-focused plan in services, traditional servers, and basic
networking combined with an innovation and revenue-growth focus in software,
advanced networking, cloud technology, and big data — areas that may as a group
deliver disruptive offerings. In taking these steps for both sides of the
company, HP is clearly targeting sustained EBITDA over the short term, and
sustainable revenue growth over a longer time horizon. Other legacy hardware
companies will have reason to consider similar strategies.
Everything as a
service
Among the companies with the highest RVGs are
leaders in the so-called XaaS sector, primarily because this nascent tech niche
has enjoyed a tremendous amount of growth recently. Consequently, companies
entering the XaaS market — which includes computing platforms, applications,
and infrastructure, delivered remotely — should be focused on staking their
claims to lucrative customer segments and not be overly concerned about
earnings margins just yet. The big XaaS players include software maker
Salesforce.com; Workday for HR programs; and Amazon, Google, and Microsoft
Azure for an array of cloud-based platforms, apps, and services. The latter
three are competing zealously for market share for their Web-based platforms.
As they compete, they drive down pricing to entice customer usage and adoption,
and they are prompting more and more companies to switch to XaaS-style models.
In all, revenue for cloud-based software, also known as SaaS, is expected to
grow at a compound annual rate of more than 20 percent throughout this decade.
SaaS is forecast to outpace traditional software license delivery by five to
one, according to market researcher IDC.
The trend is not driven only by competition. It is
triggered in part by customers’ increasing demand for flexibility that will
allow them to take advantage of new technologies. With an XaaS model, customers
are not burdened by significant upgrade costs and can more accurately estimate
the total cost of ownership of software and infrastructure. As a result,
corporate and individual attitudes about the cloud are beginning to change.
XaaS options, rather than licensing software or services per desktop, have
become much more acceptable.
Corporate and individual attitudes about the
cloud are beginning to change
Nonetheless, XaaS offerings still represent a
small minority of overall software sales. XaaS will continue to take hold, but
it will grow only as rapidly as IT departments at corporate users permit it to
grow. To adopt this new approach, IT departments need to fundamentally change
the policies and processes they rely on to source, integrate, manage, and
maintain technology. At the same time, traditional software and services firms
need to adjust their operating models and investments in capabilities to
deliver XaaS effectively. Among the capabilities that are essential for these
companies are the ability to build long-term relationships with customers
(rather than seeking quick sales); proficiency with sales incentive structures
that foster more frequent customer visits and upselling; better revenue
management and forecasting; and intelligent balancing of product R&D and
the mix between traditional software and services and XaaS. In some cases,
partnerships can be the path to acquiring these capabilities; for example, SAP
is joining with IBM to deliver SAP via the cloud. In other cases, capabilities
can be gained from new hires. Amazon has been bringing aboard ex-consultants
who are experts in industries to which the company hopes to tailor its cloud
offerings. But to transform to selling XaaS, a company’s sales force must be
retuned to emphasize ongoing customer partnerships while downplaying
traditional sales quotas. In some cases, companies should consider changing the
sales incentive structure to foster more frequent customer visits and
upselling.
As a revenue growth strategy, XaaS can be extremely
beneficial for the companies that provide it, but they will need to adjust
their financial expectations. For example, in the traditional software model,
after a sale, five years or more could elapse before a customer agreed to buy
another version of the program; as a result, after the initial large up-front
payment, an annual service fee, usually about 20 percent of the purchase price,
was all a tech company could count on. By contrast, XaaS is a slow-flowing
revenue stream often based on monthly subscription fees. So legacy license
software companies that shift even a portion of their business to XaaS must be
prepared for a sharp loss in item sales revenue. Still, considering XaaS’s
increasing allure for many customers, a good deal of licensing revenue is going
to disappear organically, so adopting XaaS in the product portfolio may soon be
a necessity and not a choice.
Software companies planning to move all or part of their
product delivery to XaaS have a number of migration options. Many companies,
such as Remedy, maintain both on-premises licenses and cloud-based delivery.
Other companies (such as Adobe) begin with a hybrid transition model and
gradually move more and more of their product lines to XaaS. Companies such as
Intuit use cloud services for new products and new customer segments, while
maintaining a licensing approach for their older offerings. And others, like
Autodesk, complement on-premises licensed products with cloud features.
Conclusion
The tech industry is being reshaped in
numerous ways. Disruption is evident in software and services delivery,
business models, the vast amount of money being poured into startups of all
stripes, the cloud, big data, entrepreneurialism, and constant innovation.
Against that backdrop, companies can no longer rely on one-note value
strategies. Analyses like RVG may indicate which immediate path holds the most
chance for short-term success, but over time, both improving margins (or, for
startups, turning profitable for the first time) and finding new revenue
streams are critical for success. In other words, legacy companies will need to
act more like their nimbler rivals — and startups must mature quickly to learn
the organizational skills and embrace scalable operating models that most
legacy companies have.
