Services Weekly Preview: November 26-30, 2018

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In this magical time between Thanksgiving and Christmas, despite racing to get as much analysis and as many predictions published before the new year, we’re able to enjoy a slight pause in the usual news cycle and company activity to reflect on 2018 and predict what will be coming in 2019. In two upcoming webinars, we will be looking at many marketwide trends, starting with an assessment of management consulting in the digital transformation age.

 

Here’s what’s coming this week:

Thursday: Last quarter when we looked at DXC Technology, we noted the company’s spike in revenue growth following its formation last year normalized to single-digit growth in 2Q18. The underlying businesses of both legacy CSC and Hewlett Packard Enterprise’s (HPE) Enterprise Services are still experiencing pressures around commoditized legacy services. This quarter TBR will highlight and discuss DXC’s recent M&A activity and its resource management strategy, anticipating similar growth results and performance.

Monday: In our full report on T-Systems for this quarter, we will note that strict execution of efforts to become an efficient organization will sustain the company’s slightly improved performance. New offerings in cloud shift T-Systems’ portfolio away from traditional IT services and increase its opportunities in a segment with growth potential.

Coming in the next few weeks: the Management Consulting Benchmark and 2019 IT Services Predictions.

Services Weekly Preview: November 19-21

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Before we celebrate Thanksgiving on Thursday and recover from all that food on Friday, we will publish some of our periodic analysis of IT services vendors, management consulting profiles, and special reports. Here’s what’s coming:

Monday: TBR’s 3Q18 Booz Allen Hamilton full report will provide analysis on one of the federal market’s most forward-thinking and risk-taking services providers. While peers struggle to cultivate a relevant data science workforce, BAH aims to cement its advantage by leading the charge around data science standardization. Its fast-mover advantage enables BAH to set the rules and challenges competitors to fall in line. Such efforts support scalability of more mature capabilities while BAH continues to evolve by exploring new business models, investing in IP and delving into emerging technologies such as blockchain, artificial intelligence and directed energy.

Wednesday:

  • TBR’s 3Q18 CACI full report examines how a traditional defense-led federal services contractor is adjusting to the incursion of commercial IT best practices into its core market areas. The report analyzes how these market disruptors can work to the advantage of a company like CACI, which is investing in software-defined open architecture systems in high-end defense technologies, such as electronic warfare and signals intelligence, to disrupt traditional military suppliers rooted in old procurement models focused on hardware-defined, proprietary and bespoke solutions.
  • In June we described BCG in our Management Consulting Benchmark as the best-positioned for acceleration among immediate peers, including McKinsey and Bain. Our new profile on the firm furthers that assessment, with a caveat the firm will need to retain talent, especially in emerging technology areas, to remain competitive, particularly with Big Four firms like PwC and EY.
  • Last week in Dallas we heard directly from Atos and the new Atos-Syntel leadership about the strategy and expectations for this multibillion-dollar, North America-centric acquisition. Our special report will detail why we think Atos’ renewed approach to the U.S. market will have a substantial impact on the company’s performance in the near term.

Services Weekly Preview: Nov. 11-16, 2018

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As we build toward the middle of the quarter, we’re wrapping up our periodic assessments of IT services vendors. Like last week, we also have some semiannual analysis on vendors in the management consulting space.

Monday: 

  • KPMG’s risk-averse culture pressured its performance, causing the firm to drop a spot in terms of revenue size among peers in the latest assessment of the management consulting practice. A potential KPMG and Bain marriage, however, could be a way for the firm to catch up with rivals and disrupt the management consulting space.
  • Continued expansion of its onshore presence, including the recent build-out of its co-innovation center in London, improves HCLT’s value proposition by enabling it to work alongside its clients to create larger-scale transformation engagements. However, HCLT faces some challenges in recruiting talent to support new centers, spurring the implementation of employee development programs.

Tuesday: Although Atos will grow revenues at a slower rate in 2018, the expansion of the company’s Digital Transformation Factory portfolio and recently announced acquisition of SIX Payment Services, which is expected to close in 4Q18, will enable the company to accelerate revenue growth in 2019. TBR’s 3Q18 Atos report analyzes the implications from Atos’ ongoing activities, such as the Syntel acquisition and investments artificial intelligence (AI) and security solutions and capabilities.

Wednesday:

  • Senior Analyst Jen Hamel examines EY’s strategy to provide clients with technological enablement of business transformation in her profile on the firm for our Fall 2018 Management Consulting Benchmark. One key takeaway: Increasing its investment in technology-enabled services, including those involving blockchain and AI, by $1 billion over the next two years will improve EY’s competitiveness with solutions-led peers IBM and Accenture.
  • We continue looking for signs Wipro will see improved performance, as its India-centric peers have, to align with its digital transformation strategy and expanded portfolio and capabilities. In this latest assessment, we’re still searching.
  • Capgemini has made changes to its portfolio, organizational structure and sales model to address rising demand from clients’ business side, rather than their technology side. In TBR’s 3Q18 Capgemini report, we will dive deeper into topics such as AI, digital marketing, and Capgemini Invent, the new global business line Capgemini launched in September.
  • In TBR’s 3Q18 Perspecta Initial Response, we will provide an overview of Perspecta’s second quarter as an independent company. Made up of Hewlett Packard Enterprise’s former U.S. Public Sector business, Vencore and KeyPoint Government Solutions, Perspecta faces some challenging financial and resource-related issues as it works to find its footing as a stand-alone company.  

Thursday:

  • TBR’s 3Q18 Raytheon Intelligence, Information & Services (IIS) full report explores how the emerging geopolitical power struggle in space and cyberspace plays to Raytheon’s strengths in cyber hardening, computer network operations, advanced analytics and AI. The report examines how IIS was able to outgrow federal IT services competitors in 3Q18 and how its deep mission knowledge in the U.S. provides a strong foundation as it pursues riskier adjacent market opportunities in volatile markets such as the Middle East.
  • TBR’s 3Q18 Leidos full report examines the company’s first quarter of year-to-year organic revenue growth since it acquired Lockheed Martin’s IT services business in 2016. The report explains Leidos’ positioning across defense, health and civilian markets and how the company is adjusting to disruption amid the federal market’s shift from bespoke proprietary technology development to configurable commercial-off-the-shelf IT solutions.
  • In our 3Q18 results on Wednesday, TBR expects Cisco Services to continue to accelerate revenue growth during the rest of 2018 and in 2019, positively affected by Cisco’s ongoing portfolio investments in and acquisitions around next-generation and software-driven solutions that generate professional services opportunities. TBR expects Cisco’s recent acquisitions and partnerships in cloud, security and networking to generate increased professional and technical support services for Cisco Services during the coming quarters.

Friday:

  • The previous edition of TBR’s Management Consulting Benchmark Profile: PwC described the firm’s efforts to make its Business, Experience, Technology (BXT) framework a companywide endeavor. Six months later, we’ve seen signs the firm’s ambitions around BXT have evolved from aspirational to operational, with global examples of the framework becoming an on-the-ground reality in working with clients.
  • Partners enable Fujitsu to enhance its core services with cloud, software and digital capabilities, helping to ease clients’ transition into emerging areas while offsetting declines from traditional services. However, without expanding its client base outside of Japan, Fujitsu could face challenges in maintaining revenue growth.

Cloud repatriation follow-up: Do you really know the value proposition of cloud?

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A few weeks ago, I blogged my thoughts about cloud repatriation and how it feels like an over-emphasized trend. In my professional analysis amid researching various reports and interacting with data center vendors, one of the key pieces of the cloud repatriation narrative is that customers will move to cloud without a full picture of the costs and ultimately retreat to a more predictable environment. Seems like a reasonable hypothesis, but has this been tested? Also, is cost really the core decision driver?

A recent call with an enterprise IT buyer shone light on this topic, as much of their story about consuming IT didn’t align to the market generalizations. For starters:

  • The buyer is in the healthcare industry but is using cloud services, even migrating some critical applications like ERP to a SaaS-based solution. Generally, it’s thought that the industries with sensitive data will stay away from cloud solutions.
  • The company typically keep $500 million in the bank at any given time, meaning the perceived challenge of capex outlay associated with on-premises solutions isn’t much of an issue to drive it to adopt off-premises cloud solutions.
  • But the real kicker? The customer indicated its cloud-based solutions are at best cost-neutral and sometimes even more expensive than their on-premises counterparts.

This came as a bit of a surprise to me, as these elements are counter to the typical IT industry narrative. If an enterprise is investing in an off-premises solution already knowing they will pay the same or more than an on-premises solution, what’s the point?

Let’s look at this particular customer’s cloud journey. Their first foray into enterprise cloud was, like for many businesses, using Office 365 and products such as Exchange for email. Based on the value seen from this implementation, including reduced management overhead and end-user benefits, they started adopting cloud-based offerings in other areas of the IT stack.

When describing the organization’s process for making decisions around acquiring IT solutions, the buyer described a fairly complex, quantitative strategy for assessing the ROI of any given solution over a three-year period. The assessment includes four facets:

  1. Will it save time? This can include making IT employees more efficient or enabling business unit employees to improve their workflows.
  2. Will it save money? A detailed calculation considers elements like license costs, management overhead and how these will change over the three-year period.
  3. Will it make money? This particular buyer works for an organization that acquires other companies often. The buyer described a scenario where using cloud solutions helped integrate an acquisition target’s data within two weeks and enabled a new product to be launched within a month of the acquisition.
  4. Will it reduce risk? Risk can take many forms, from risk of an IT outage to risk of interrupted operations or compromised IT security.

This is one example from one enterprise, but it illustrates the point that cost is far from the only factor being weighed when making choices about how IT is going to be delivered. Or at the very least, cost is not simply what you pay for a solution; decision makers must consider the many risks and benefits that spider across an organization. A higher fee for an IT solution might be a small price to pay if it increases your time to market by three times or more. Moral of the story: Know what the actual criteria are for your customers’ decision making. You may be failing to sell to their most important buying points. Or, you may be sending the wrong message!

Atos expands reach in North America through the acquisition of Syntel

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On Oct. 9, Atos completed the acquisition of Syntel, adding close to $1 billion in revenues, 89% of which were generated in North America in 2017, as well as over 23,000 employees. This month, TBR analysts will travel to Dallas to hear further details on Atos’ plans with Syntel and further assess what this will mean for Atos and its competitors.

Syntel expands Atos’ transformational capabilities in North America

Syntel provides critical scale for Atos’ Business and Platform Solutions (B&PS) division in North America and enables Atos to expand its digital transformation activities in the region. As Syntel’s revenue is fully driven by B&PS activities, such as in digital, automation and robotics, the acquisition will enable Atos to diversify its revenue in North America, which has been largely reliant on Atos’ Infrastructure and Data Management (IDM) division. Selling Atos’ offerings in cybersecurity, big data and IDM to Syntel’s acquired client base as well as offering Syntel solutions to Atos’ global clients and pursuing large-scale holistic digital transformation projects will drive revenue growth for Atos through 2021.

Syntel’s intelligent automation tools enable Atos to deliver cost-effective solutions to clients

Atos expects to generate $120 million in cost synergies through the acquisition, which, together with the addition of Syntel’s efficient business model, will boost Atos’ profitability. While G&A rationalization, real estate management and procurement will drive cost synergies, the main lever will be the rollout of Syntel’s delivery model for Atos’ large B&PS accounts, which make up $1.3 billion in annual revenues and 36% of B&PS revenue. Notably, Atos plans to adopt Syntel’s delivery model and integrate its processes; tools, such as intelligent automation tools called SyntBots; metrics; and 18,000 employees in India to improve Atos’ cost base and augment B&PS operating margin, which was 7.4% in 1H18.

Atos increases cloud services opportunities

Reinforcing its cloud capabilities through the acquisition of Syntel enables Atos to expand client reach in North America and increase hybrid cloud orchestration activities. Atos has already rebranded Syntel to Atos Syntel, which is now a separate Atos brand, and Syntel’s Cloud Services offerings are being marketed to clients as Atos Syntel Cloud Services. Syntel provides Atos with added expertise from more than 50 cloud projects and cloud services offerings that better enable Atos’ enterprise IT solutions to deliver a “digital backbone” to clients. The Atos Syntel Cloud Services offerings are supported by Syntel’s IP-based accelerators and automation tools such as the SyntBots. TBR expects Atos will work toward a unified cloud services portfolio by integrating Atos Syntel Cloud Services with Atos’ existing cloud capabilities, such as Atos Canopy Orchestrated Hybrid Cloud.

Atos is an expert in integrating acquisitions, such as that of Syntel

Let’s look at Atos’ track record on acquisitions: Following its strategy to add digital technology capabilities and intellectual capital, and augment its position in e-payments, the company acquired seven companies during 2017 and announced three acquisitions in 2018, two of which — Syntel and Air-Lynx have closed — while SIX Payment Services is pending approval. The company has a history of successfully integrating acquisitions, some small and others large, such as Siemens IT Solutions and Services (SIS), which added approximately 28,000 people to Atos in 2011. SIS had experienced lingering revenue declines and low profitability levels; however, during the integration process, Atos was able to restructure SIS so that Atos’ profitability was not negatively affected and improved in the following years. TBR expects Syntel will have an overall positive affect for Atos in terms of client reach; expanded solutions capabilities, especially around digital, cloud and automation; and profitability. Syntel, which had an operating margin of 25% in 2017, driven by efficient and automated processes, will boost Atos’ profitability as Atos adopts Syntel’s model of operations in B&PS.

Services weekly preview: Nov. 5-9, 2018

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Well into the third quarter of industry earnings and our periodic assessments of IT services vendors, TBR’s analysts this week will also share their semiannual analysis on vendors in the management consulting space

Monday: In 3Q18 Infosys signed 12 large deals with a total contract value over $2 billion, but the company’s delivery framework remains fragile as Infosys maintains its margin-first culture. In our full report on Infosys, Senior Analyst Boz Hristov notes that open-source solutions will support Infosys’ efforts to compete on price as it morphs its value proposition toward becoming a platform-based company. Returning to sustainable double-digit revenue growth will remain a mirage in the next two years.

Tuesday: Senior Analyst Jen Hamel’s initial take on IBM Services’ 3Q18 earnings performance noted that while internal transformation efforts expanded margins, stalled revenue growth shows the company’s work is far from over. The full report expands upon the implications of IBM’s ongoing transformation, including the recent announcement of plans to acquire Red Hat, for IBM Services’ future as a leading IT services vendor.

Wednesday:

  • Analyst Kevin Collupy’s initial report on DXC Technology’s (DXC) quarterly earnings will explore the company’s approach to software and partnerships and its continued use of acquisitions to fill talent and portfolio gaps. We expect tepid growth through the remainder of the year and likely modest organic year-to-year declines, highlighting the importance of strategic acquisitions.
  • In the last edition of the McKinsey & Co. Management Consulting Benchmark profile, I anticipated a slowdown in the firm’s acquisition pace and questioned whether McKinsey could assimilate new capabilities and roll out new offerings, especially around digital, design and analytics. This profile publishing this week will detail how McKinsey performed through the start of this year and how the firm has positioned itself well to benefit from competitors preparing the market for digital transformation.

Thursday: Analyst John Caucis’ initial response to DXC’s earnings and the fiscal performance of the company’s healthcare IT services (HITS) business will cover a mix of positive and negative developments in the fiscal quarters ended 2Q18 and 3Q18 (semiannual report). DXC continues to execute strongly in APAC, particularly in Australia, but indications of difficulties in Europe began to surface in 3Q18. Meanwhile in DXC’s core U.S. market, disruptions appear to be lingering from the spin-merge with Hewlett Packard Enterprise (HPE) Enterprise Services, delaying a rebound in healthcare IT services growth.

Friday: In this edition of the semiannual look at Accenture’s management consulting practice, Boz will note that the company will rely on patented, artificial intelligence-enhanced solutions to maintain revenue growth momentum and withstand threats from the Big Four and IBM. However, adding tech-centric offerings and engineering-trained resources may pressure its management consulting brand, while a potential large-scale management consulting acquisition could help the company address buyers’ perception.

Voice assistant volume is increasing

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A survey conducted by Adobe Analytics found that 32% of U.S. consumers owned a smart speaker in September 2018, compared to 28% in December 2017. The report also projected that near half of the U.S. consumer base could own one by the end of December 2018, supported by Adobe Analytics’ finding that nearly 80% of smart speaker sales occur during the holiday season. It is just one study, and there are more conservative studies out there ― but even if the data isn’t completely on the mark, it does uncover the trend of voice-controlled devices gaining ground inside consumers’ households despite use cases and monetization still being blurry.

I own four Amazon Alexa-enabled devices myself: two Echo Dot smart speakers and two Fire TVs. Of the Echo Dots, one was given to me by a colleague to play around with, and another I bought for about one-third the list price from acquaintances who had received it as a gift from their extended family and left it unopened because they felt it was “too creepy.” In our household, the Echo Dots have been used as glorified hands-free music players in our kitchen and one of our bathrooms. The Fire TVs are used as media players first and foremost. Sometimes, we try some of the new skills Amazon sends along in update emails as a fun diversion, but usually that is a one-off activity. I am deeply invested in the Amazon ecosystem, having been a Prime member since its debut and a fan of Prime Video, but it is still challenging to find ways to use Alexa smart-home devices to enhance my other Prime benefits or drive me to Amazon’s e-commerce business.

Adobe’s research seems to align with my anecdotal experience, noting that among the most common voice activities* are asking for music (70% of respondents) and asking fun questions (53% of respondents). The only other activity above 50% is asking about the weather (64% of respondents). So yes, people are using them, but these are not skills that require much depth or complexity or that drive additional revenue for Amazon.

Therein lies the problem for voice-platform providers such as Amazon and Google (Microsoft and Apple are also players, but I don’t believe they are as developed as Amazon and Google are in the smart speaker and voice assistant space). In an ideal world, voice assistants would provide platform companies with a wealth of consumer data as users query the devices about their everyday needs. Also, voice assistants can be a new conduit to monetization through new applications or — especially in Amazon’s case — to lowering barriers to the purchase of goods. However, most complex tasks, such as ordering a ticket for the movie you’d like to see tonight, finding out when the beach is open, or buying an outfit for an upcoming wedding, are still much easier via a smartphone or laptop interface. The Adobe study found that of the 32% of respondents with a smart speaker, only 35% and 30% used voice interfaces for basic research or shopping, respectively.

Improving the use cases, or “skills,” of voice assistants will be critical for platform vendors to increase the use of these devices for complex tasks and to elevate smart speakers from smart radios and novelties to gleaming data gems. TBR expects this to be the major battleground between voice assistant and smart speaker providers moving forward as the form factor has been relatively proved. TBR believes Google has a slight advantage due to its heritage in data mining behind the façade of services as well as its Android and Chrome cross-platform tie-ins (a lot of relevant user data is already in Google, such as contacts, schedules, and often email). Amazon is no slouch either due to its investment spend, growing media empire and robust e-commerce platform, which Google lacks. Apple could be a dark horse; however, its Siri is still weaker on an artificial intelligence (AI) basis and the HomePod’s pricing makes it an unlikely easy gift.

The next frontier for all of these platform providers is in the commercial space, an area we may see Microsoft put much of its effort into while leaving the consumer space for better-suited peers. In fact, collaboration between Microsoft and Amazon on voice and smart speakers may confirm this. Using voice assistants and smart speakers to query analytics or gain business insights or employing them as a “smart secretary” in conference rooms are areas TBR sees as avenues for commercial expansion. TBR has seen slightly different approaches from Amazon and Google in the commercial space. Amazon, likely with Microsoft support, focuses on the office with Alexa for Business, while Google seems to be positioning its voice AI and smart speaker technology to serve as an interface for a business’s customers.

However, as with the consumer space, the use case must be proved, the skills must be ironed out, and existing commercial infrastructure must be modified to support voice assistants and smart speakers. And despite furious investment in these possibilities by the major platform players, TBR doesn’t expect to see Alexa widely adopted in the boardroom for at least another two to three years. For now, I believe smart speakers will continue to find their way into homes as a novelty or curiosity for tech-excited people and early adopters, contributing to slow but steady growth, or as an easy, cost-effective tech-based gift, driving additional bursts of increased unit sales during the holidays.

*Voice activity data includes devices that are not smart speakers, such as smartphones.

Big Blue opens its arms, and its wallet, to Red Hat

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Red Hat’s projected growth is enough to justify the hefty purchase price

On Oct. 28, IBM (NYSE: IBM) and Red Hat (NYSE: RHT) executives announced a proposed acquisition ― one that will be the industry’s third-largest acquisition should it gain approval. The deal, valued at $34 billion, would bring Red Hat into IBM’s hybrid cloud team, in its Technology Services and Cloud Platforms (TS&CP) group, where its IaaS (formerly SoftLayer), PaaS (formerly Bluemix) and hybrid management capabilities reside.

While the sheer magnitude of the deal may surprise some, the underlying reasons do not. IBM’s cloud strategy was sorely due for a boost, and Red Hat has been looking for a potential buyer for quite some time. Stefanie Chiras, a 17-year IBM vet, joined Red Hat as the VP and general manager of the Red Hat Enterprise Linux (RHEL) business unit in July, likely to lead that group through the planned acquisition. The potential acquisition would also be aided by portfolio synergies around Linux on IBM hardware and Kubernetes. Additionally, IBM is pervasive in the large enterprise market while much of Red Hat’s revenue is channel-led.

What’s most important is that IBM listened to its stakeholders and the broader market, realizing that while its cloud business was growing consistently at around 20% to 25% year-to-year on a quarterly basis, that was not enough to move the needle materially to more effectively compete in cloud. The company’s recognition that it should not always promote all-IBM solutions is a noteworthy shift. Though IBM has had technology partnerships for some time, there was always the underlying perception that it would push its own solutions ahead of others, regardless of customer needs. Its recent and ongoing focus on hybrid IT enablement has changed this; and now, bringing on an open-source company could change the game for IBM.

Sticker shock fades once you factor in the rest of the numbers

Historically, initial public offerings (IPOs) and sales of more traditional technology and software companies have been valued at around 5x their annual revenue. However, in recent years, as more cloud-native companies with subscription-based business models go public or get acquired, this multiple has steadily shifted upward. As a rather extreme example, Cisco (Nasdaq: CSCO) bought AppDynamics for $3.7 billion, a valuation of nearly 16x AppDynamics’ annual revenue, even though in the week prior to the purchase AppDynamics had been valued at $1.9 billion on an annual revenue of approximately $220 million as the company readied for its IPO.
Much of the speculation around this monstrous deal relates to how IBM can and will fund such a hefty purchase. To put this massive $34 billion figure into perspective, Red Hat’s trailing 12-month revenue for the four quarters ended Aug. 31, 2018, was just shy of $3.1 billion, indicating the deal is valued at 11x Red Hat’s annual revenue. If Red Hat were to stay on its double-digit growth pattern and trajectory*, its revenue and operating income would be projected to more than double by the close of 2021, benefiting from access to IBM’s vast enterprise customer base.

These projections help IBM justify the large purchase price. Additionally, it is likely that the purchase price per share was set at least a few weeks ago, when there were more Red Hat shares available and at a higher price. On Oct. 1, Red Hat was trading at $133 a share, compared to the $117 per share price it was trading at on Oct. 26.

Synergies make the acquisition possible; success will come down to execution

Organizational structure

The proposed acquisition poses significant integration challenges for IBM if approved. Though the company has been successful in the past with integrating software acquisitions, it has yet to make a purchase this large, and this is the first major software acquisition since the company reorganized and brought software subgroups across its various business units a couple of years ago, eliminating a dedicated software business unit. Additionally, none of the formerly acquired companies have run as stand-alone units as Red Hat is expected to be.

Red Hat’s proposed position as a stand-alone unit in TS&CP could have varying results. IBM Services’ culture and cumbersome processes could stifle Red Hat’s software-led mindset, culture and innovation. Alternatively, Red Hat’s products could be pulled through in an unprecedented number of Services engagements the company has yet to see due to its much smaller size and scale. This second scenario, however, would only be possible if IBM Services and consultants can differentiate from Red Hat’s existing systems integration partners to maintain IBM’s status as the largest services provider around Red Hat and Linux. Whether or not those partnerships will stay at the strategic levels they are at today, or at all, remains unclear.

Red Hat CEO Jim Whitehurst would report to IBM CEO Ginni Rometty. While it is very likely he would stay with IBM for the year or so required and then retire, there is the possibility, and this is pure speculation, that IBM could be priming him to be a contender for the position of IBM CEO should Rometty look to retire soon.

Go to market

Undoubtedly, IBM has set its sights on reaching more midmarket customers as its large enterprise customer base is slower and more resistant to move to cloud. Red Hat’s prevalence in the midmarket will surely help open the doors to cross-sell IBM solutions and services to these companies, if pricing is adjusted for smaller companies. Additionally, IBM will gain access to a Red Hat developer community of more than 8 million. On the other side of this, Red Hat also can bring its solutions upmarket to IBM’s largest enterprise customers.

Much of IBM’s focus as of late has been on helping customers link on- and off-premises environments and sharing data across truly hybrid environments. Its large Services arm and broad portfolio set have helped offset some legacy software and services revenue erosion in past quarters. While Linux is already relatively pervasive across the market and OpenStack has yet to garner significant demand or traction, Kubernetes is the open-source solution of choice at the moment and will be in coming quarters. IBM continues to update its IBM Cloud Private portfolio centered on Kubernetes, which can also run on OpenShift, presenting an area of immediate portfolio synergy between the two companies. The incorporation of additional open-source technologies into the mix as well as Red Hat’s interoperability with third-party cloud and software solutions only help position IBM as an increasingly technology-agnostic hybrid enabler.

Peer implications

Despite the size of the acquisition and the attention it is garnering, IBM’s cloud competitors will not face substantially altered challenges should the deal go through. Amazon Web Services (AWS) and Microsoft (Nasdaq: MSFT) will continue to dominate the public cloud IaaS and PaaS market. The two have increasingly embraced open-source technology integrations in their proprietary ecosystems, only enabling them to get bigger as they can also work with RHEL customers.

We believe that if this acquisition were to materially impact any single company, it could be Google (Nasdaq: GOOGL) and/or Oracle (NYSE: ORCL). Google struggles to compete at scale with AWS and Microsoft and does not yet have the same permission to play in the large enterprise segment. With IBM, Red Hat would gain that permission almost immediately. Oracle’s Linux offerings are based on RHEL, which could complicate a competitive relationship between IBM and Oracle. While Oracle may have more pressing areas to focus on and invest in, such as Kubernetes in tandem with its peers, the company could, should it choose not to work closely with IBM when Red Hat is integrated, look to acquire another Red Hat-like company with expertise and capabilities in open source and Linux in particular, such as Canonical or SUSE, which was just sold by Micro Focus (NYSE: MFGP) to private equity firm EQT for $2.5 billion.

Whether by R&D or acquisition, money can’t buy SaaS performance

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The SaaS market appears to provide an easy opportunity for vendors to garner significant revenue and growth. SaaS is the largest segment of the cloud market — bigger than the IaaS space, which draws so much attention due to leaders Amazon Web Services and Microsoft Azure. The SaaS market is also much more fragmented, littered with thousands of providers, which would seem to imply that consolidation is a foregone conclusion. However, even for three of the largest leading SaaS providers, the investment level required to compete in the space remains high, and even spending billions of dollars in R&D and acquisitions does not guarantee success.

This is not to say that these billions of investment dollars are all for naught. Despite being around for more than a decade, the SaaS space remains quite immature. Customers are still figuring out which of their applications can be moved to cloud delivery, and how, when and with which vendors those moves can take place. Until a longer track record exists for making these decisions and vendors consolidate disparate offerings into packages more closely resembling integrated solutions, the market remains very much in flux. It’s not the functionality holding back the adoption of hybrid solutions, it’s the difficulty of integrating and managing the multicloud and multivendor solutions. In the meantime, vendors such as Oracle, SAP and Workday have no other choice but to continue accelerating their investments. Their dollars will not buy SaaS performance in the short term, but this is the only way these vendors have a shot as the SaaS space becomes more predictable.

Oracle is in too far to turn back now

By virtue of its long legacy in a diverse field of software, Oracle finds itself in a unique position with cloud solutions. Aside from databases, Oracle is a company built on acquisitions, and that approach holds true with its expansion in cloud. After first downplaying the overall concept of cloud delivery, even while acquiring cloud assets, the vendor recently quickly shifted its messaging and doubled down on internal- and external-driven innovation. The results from a dollar perspective are laid out in Figure 1, representing a steady and significant stream of acquisitions focused on building out mainly SaaS offerings and R&D that funds cloud solutions across the spectrum of IaaS, PaaS and SaaS. The significant amount of Oracle’s investments is undeniable, but the returns are far from overwhelming. The downfall of Oracle’s SaaS investment plans played out quite publicly, as the company first bet it would become the first SaaS/PaaS vendor to achieve a $10 billion run rate, then recently changed its reporting structure midyear to blur the actual results.

 

Oracle maintains worse performance than SAP and Workday for the return on its acquisition and R&D investments, spending more on these investments than the company generated in total cloud revenue during 2016, 2017 and 2018 (estimated). That does not mean Oracle is without successes, however, as the purchase of NetSuite, reflected in Oracle’s large acquisition expense in 2016, contributes to revenue growth and complements the organic development of Fusion Cloud ERP. A lot of Oracle’s struggles in cloud come from organic initiatives, such as its PaaS and IaaS services, which have not taken root with customers despite aggressive sales tactics. Those categories of services account for a significant portion of Oracle’s R&D investments over the past three years, but still generate relatively small revenue streams for the vendor. Nevertheless, despite the investment outweighing the associated revenue contributions, we believe Oracle will and should remain committed to its current cloud strategy. It may not pay off in the near term, but these investments are the best shot for Oracle to execute a longer-term cloud turnaround.

SAP is making all the right financial decisions, but still falling short

Though still acquisitive, SAP’s cloud strategy has been more focused on internal innovation compared with Oracle. A more even mix of R&D and acquisition investments, combined with an earlier commitment to cloud delivery, is producing a better rate of revenue return for SAP, as shown in the graph below. SAP ranks fairly close to Oracle in total cloud revenue but is achieving those run rates after incurring significantly fewer R&D and acquisition expenses. TBR estimates SAP’s combined R&D and acquisition investments for cloud were $6 billion for the past three years, compared with more than $21 billion for Oracle over the same time period.

Despite the comparatively positive financial returns for SAP in cloud, the vendor is still struggling with multiple elements of its portfolio. After allowing Salesforce to capitalize on the shift to moving front-office apps to cloud, SAP recently started circling back to carve out territory in that domain. Through multiple acquisitions in the customer experience space and new messaging, SAP is making a concerted push, but it faces an uphill battle winning more market share in that space. Furthermore, SAP’s effort with SAP Business Suite 4 HANA is a long-term one, and in the meantime, assets such as SAP Cloud Platform are underrepresented in the platform space. The net is that SAP has managed investments well and grown revenue in cloud but is still not achieving at a scale that ensures the vendor’s leadership in the SaaS space.

Workday is opening its wallet after trying the DIY route

Historically, Workday has been more reliant on internal R&D as the sole means of advancing its cloud strategy compared with Oracle and SAP. That certainly does not mean the company was shy about entering new markets or delivering new products, as Workday has rapidly increased its activities in both regards over the past three years. The addition of student, financial and now platform offerings illustrates how broadly Workday has expanded its portfolio beyond core human capital management (HCM) offerings. Part of Workday’s reliance on R&D comes from its core focus on a “single line of code,” which provides simplicity and consistency in the vendor’s offerings to customers. Integrating multiple offerings and services is part of the challenge with acquisitions, which Oracle and SAP know all too well. Workday’s past acquisitions have always been functionality-focused and intermittent. The company’s three acquisitions in 2Q18, including its $1.55 billion purchase of Adaptive Insights, is a departure from that strategy but is likely not indicative of broader plans to acquire more fully baked applications. Workday Cloud Platform will allow Workday to leverage partner-developed, inherently integrated technology to expand portfolio breadth.

 

The assumption that Workday’s acquisition-lite approach to investment would be advantageous is not necessarily true. Even without significant acquisitions, Workday’s investment ratio (R&D + Acquisitions/Cloud Revenue) is higher than SAP’s for the three years from 2016 to 2018. Workday had a lower ratio than Oracle, which is spending aggressively on acquisitions, but Workday ranked above SAP in internal R&D investment level proportional to revenue. Additionally, Workday’s streamlined “single line of code” approach is not guaranteeing success in new product categories. HCM revenue growth remains strong, but Workday’s new expansions in Financials and Student are not seeing accelerated early revenue growth. The new offerings are certainly growing, but not at the rate one would expect given the strong HCM base into which they can be cross-sold. The large acquisition of Adaptive Insights could be part of a change in strategy to add inorganic revenue and could lead to greater cross-selling possibilities for the Financials business.

Customer preferences are forming around hybrid and shifting around open source as vendors focus on acquisitions

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Prebuilt devices are a ray of clarity amid the fogginess of hybrid

Hybrid can be a difficult thing to define in cloud computing. The term “hybrid” is overused by vendors but underused by customers, causing general confusion over its definition as well as solid examples of hybrid solutions. An area of the market that cuts through those areas of confusion is hybrid cloud integrated systems. These are physical devices (appliances) that are designed to integrate with public cloud services and can be used in customers’ own data centers. The idea that customers can physically touch the box and also integrate with external cloud services makes integrated systems one of the easiest and most obvious hybrid scenarios.

Examples of integrated systems solutions include Azure Stack from Microsoft and its hardware partners and Cloud at Customer from Oracle. While adoption and usage of these hybrid cloud solutions remain limited, the trend is picking up momentum and is prompting vendors such as Amazon and Google to move closer to competing in the space, particularly as customer demand from heavily regulated industries favors local versions of vendor-hosted cloud infrastructure. For example, Amazon Web Services (AWS) and Microsoft are the two front-runners in the race to win the U.S. Department of Defense’s Joint Enterprise Defense Infrastructure (JEDI) contract. While AWS has largely been seen as the overall favorite, its Snowball Edge offering does not meet the same bidirectional synchronization requirement of the tactical edge device that Azure Stack does.

Kubernetes season is in full swing as OpenStack falters

For large enterprise customers, open-source technologies have garnered much interest as part of their cloud strategies. The ability to utilize solutions that provide the same backbone as large cloud providers while maintaining the control associated with open source has been an attractive value proposition for those with the resources to implement and manage them. However, predicting which technologies will be the most commonly adopted has been more challenging, creating uncertainty around frameworks such as OpenStack, which has yet to garner significant momentum in the market.

Compounding the hurdles for OpenStack to overcome continues to be the ongoing explosion in growth among public cloud IaaS front-runners AWS, Google, Microsoft and Alibaba. OpenStack founders and former OpenStack pure plays are making notable shifts toward Kubernetes. The difference, though, is that Canonical and Red Hat are still holding onto OpenStack, while others, such as Rackspace, Hewlett Packard Enterprise, IBM and Mirantis, de-emphasize it.

Customers increasingly understand the benefits of containers and container orchestration platforms and embrace the portability and interoperability they provide. According to a recent interview done as part of TBR’s Cloud Customer Research Program, a retail SVP, CIO and CTO said, “You need to make sure there are escape clauses in your contracts in case you need to get out. Once you’re in it, you’re pretty much married, and that divorce is really bad. That’s the reason we have a container. … Because if it starts to get too expensive, we want to pull it off quickly.”

This is just one example of the immediate enterprise benefits of container and container orchestration platforms, which can change the game for enterprises in terms of their cloud adoption road maps and long-term cloud plans.

Hybridization is becoming even more widespread than customers realize

While pre-integrated devices are the most obvious examples of hybrid usage, the vast majority of activity is occurring in more subtle situations. This activity is driven by the desire among vendors to sell broader solutions and the desire among customers to implement services that integrate with existing and other new technologies. The good news for both sides of the market is that there are more capabilities than ever to put those more cohesive, integrated solutions in place.

Salesforce, whose solutions are commonly integrated into hybrid environments, has taken a notable step into the hybrid enablement space by acquiring MuleSoft. The acquisition, which closed on May 1 at the start of Salesforce’s FY2Q19, brings MuleSoft’s well-known integration Platform as a Service (iPaaS) solution and services into Salesforce’s arsenal. The implications for Salesforce, its customers and the market are vast, as the company can create connections between its applications and the variety of other cloud and legacy systems residing in customers’ environments. Salesforce quickly leveraged the iPaaS technology, bringing Salesforce Integration Cloud to market within the first few months of having MuleSoft on board, enabling customers to augment their Salesforce applications and derive greater insights from their non-Salesforce data.