Wednesday, May 20, 2015

2015 Technology Industry Trends

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.