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As inflation rears, will it throw off SaaS and ITO operating models

Who today has experienced a long-term economic inflationary period?

Inflation is very much in the U.S. news as it reaches 40-year highs. This means a person has to be near the end of their professional careers to have experienced the previous inflationary period. One of the authors dimly recalls his economics professors trying to parse what, at the time, was called stagflation, which impacted the United States in the 1970s. Oil price shocks drove up prices, while unemployment remained high. Inflation previously had been explained as too many dollars chasing too few goods and was generally assigned to economies overheating because of very low unemployment rates.

Today economists seek to assess economic fundamentals to predict whether this inflationary spike will be temporary or persistent. Factors suggesting a short-term spike revolve around the well-publicized supply chain disruptions coupled with record savings levels during the pandemic when discretionary spending on things like travel and restaurant meals was greatly hindered and retail spending shifted from in-store shopping to e-commerce.

On the other hand, some economists point to persistent government deficits due to pumping money into the economy. Given various regulatory and economic uncertainties, that money has been sitting on the sidelines. Further stock market run-ups in valuation have been attributed to investor money seeking higher returns that can be achieved in traditional savings and bond ownership because of low interest rates on these conservative investment instruments.

Partisans will selectively mention these factors to explain away or criticize the current economic climate. Businesses, on the other hand, have a recently dormant financial risk rearing its ugly head that can dramatically impact long-term financial forecasting.

So what are the technology company business models where inflation has near term impact?

Transaction-based businesses in  the IT industry will be able to follow traditional methods of passing costs on to the customer. But, for those business units working from Anything as a Service (XaaS) subscription models, ITO contracts and infrastructure managed service agreements, the near-term impact could be more acute.

Cloud-enabled SaaS models are a relatively new phenomenon as Industry 4.0 gains momentum. Proponents of these business models also assert that legacy business model metrics and analysis do not apply given the majority of selling expenses are recognized in the first fiscal quarter of multiyear agreements while the revenue is then recognized ratably over the contract term. As such, the financial spokespeople for these business models lean heavily on relatively new business metrics — annual recurring revenue (ARR), net dollar revenue retention and lifetime customer value — that chart a forecast course for when operating profits will materialize.

ITO contracts have had a somewhat longer evolution, starting as multiyear deals where vendors could reap greater profits as operating costs declined due to the increased automation of the overall monitoring and maintenance. These contracts then moved to shorter-term durations and, more recently, have stipulated cost decreases over time such that any operating costs savings created by the vendor are passed along, or at least shared with, the customer. The ITO market has likewise seen a shift or rebranding of these customer offers into infrastructure managed services to pivot the contract model to be more in line with SaaS constructs.

When inflation was last a top-of-mind economic consideration, most IT was on premises and operated by company personnel. TBR seriously doubts strategic scenario planning for these new subscription consumption models prior to perhaps late 2020 anticipated the current inflationary levels and their potential operating impact.

What is the immediate inflationary risk to XaaS and ITO business models?

SaaS models take several years to generate profit in what is variously described as the flywheel effect or the force multiplier effect. Increased labor and utility costs beyond forecast and tethered to long-term contracts will add several percentage points of operating costs to these models. In this sense, the newer the SaaS operating model the less risk it will have to cost structure as it has less renewed revenue. TBR expects the more mature the SaaS model, and greater amount of accrued or committed revenue, the more adverse the bottom-line operating impact.

The ITO market, on the other hand, has shown persistent declines, resulting in consolidations and divestments to profitably manage eroding streams traditional ITO vendors seek to convert into managed services agreements. The inflation impact on costing will amplify the need to infuse these business practices with more automated capabilities or increased low-cost (typically offshore) labor as offsets. Still, the operating profit declines in this space will likely worsen unless vendors seek to negotiate incremental cost increases that customers may or may not be willing to accept based on their own issues with cost containment.

What go-forward tactics are in the technology vendor toolbox to mitigate inflationary impact?

Inflation is not new, but the operating models prevalent now were not around when we last experienced it. Business strategists still have a blend of initiatives they can embrace to preserve their operating models and their customer relationships:

  1. Market education: Transparent declarations on the cost impacts to the vendor business and any suggestions of sharing the burden with customers can preserve customer loyalty.
  2. Customer research in existing brand perception. The XaaS Pricing team has a very good blog outlining the Van Westendorp Price Sensitivity Meter and its applicability setting B2B SaaS pricing strategy. That research methodology can assist vendors in level setting where they stand with customers on the value perception and give pricing strategists a line of sight into how much room they have within their brand perception for implementing price increases.
  3. New contract language for price increases: The historic quiet period on inflation, coupled with the innate reality within technology of “faster, better, cheaper,” has customers expecting price reductions for IT that will require true customer education around inflation as an offset to those prevailing market expectations. This will not help with the inflationary impacts on the existing contracts that must be honored, but can establish a new go-forward pricing model that can take into account a business risk largely dormant for the better part of 40 years.

Inflation as a business risk will persist for the foreseeable future. TBR will be assessing it closely as public companies report their earnings and release their financial filing documents.

A Roaring ’20s for the Middle East?

PwC on post-pandemic digital transformation in the Middle East

On their March 23 webcast, “Transitioning to the New Normal,” PwC’s Middle East leaders discussed the results of their 24th annual CEO survey, focusing on findings specific to their region. Guided by Middle East Clients and Market Leader Stephen Anderson, the conversation highlighted four themes: growth, lessons learned, transformation, and threats, particularly around cybersecurity and talent. In addition to the respondents’ overall confidence that 2021 and 2022 will be growth years for the region, one highly notable findings was that 59% of Middle East CEOs surveyed are planning double-digit increases in their investments in digital transformation this year. Not only does that percentage track closely with TBR’s Digital Transformation: Voice of the Customer Research, but it also far outpaces any other area for investment, at least among Middle East-based CEOs.

The PwC leaders noted that while 2020 put considerable revenue pressure on most regional businesses, companies also used the pandemic as a catalyst to cut costs. But for 2021, cost-efficiency trails digital transformation as a priority. Again, this tracks closely with our own research, which found that companies are prioritizing investment in cloud and managed services over digital transformation for this year. Cloud demand stems directly from the pandemic and the move to remote working, while the increase in demand for managed services has been building for years.

In TBR’s recent survey, over two-thirds of respondents are planning to increase their budget for managed services over the next year, which will create opportunities for vendors that can tie cost savings to managed services solutions. Also echoing TBR’s research around global delivery and automation, PwC’s survey found that “productivity through automation and technology” ranked as the top “workforce strategy” in 2021, jumping from 6% of respondents in 2016 to 46% in 2021.

The twin threats of cybersecurity and talent

In discussing threats to growth in 2021, the PwC team described the Middle East as being ahead of the rest of the world in terms of both reducing headcount early in the pandemic and now rehiring to meet returning demands. The challenge, shared globally based on TBR’s discussions with IT services vendors and consultancies over the last year, remains finding skilled talent, upskilling current talent and managing the overall talent base, especially in a highly competitive market for digitally versed professionals. PwC’s Middle East team suggested closer cooperation between commercial entities, local governments and higher education providers would be key to regional companies being able to recruit enough skilled talent in the near term. (Quick side note: PwC has a product that may be instrumental in tackling that talent shortage.)

As for cybersecurity, the PwC team acknowledged the reality that the 2020 rush to the cloud, sparked by the move to remote working, opened the doors to new cybersecurity vulnerabilities, leading over 40% of Middle East CEOs in PwC’s survey to rank security as a threat to growth this year. According to TBR’s Digital Transformation: Voice of the Customer Research, 26% of the surveyed respondents in Europe see regulatory compliance risk as an impediment to successful digital transformations. In the same study, 50% of the respondents overall said the most critical attribute for vendor selection remained working knowledge of digital-related security, risk and privacy issues.

But we made it through together

Thankfully, the webcast didn’t end on the pessimistic note of threats and talent shortages. Instead, the PwC team observed that the region’s people — across all businesses and professions — had been “stress tested,” had become more adept at new ways of working, had found a new appreciation for “others’ well-being,” and were poised to build on the lessons learned and change atmosphere and, perhaps, welcome in a new Roaring ’20s.

Throwing a bit of a black cloud on that optimism, in the PwC CEO survey, the widest gap between Middle East CEOs and the global respondents occurred on the subject of “geopolitical uncertainty,” which CEOs from the Middle East saw as a far larger threat to growth. In contrast, Middle East CEOs were markedly less concerned than their global counterparts about overregulation as a hindrance to growth, perhaps pointing the way toward what TBR believes could be a path to success in the region in 2021: follow the Dubai, United Arab Emirates, promise of no new government fees until 2023 and the Omani shift toward more access for investors. Using competitive pressures within the region to continue to make the Middle East as a whole more attractive to global investment and trade will likely remain a key strategy for local CEOs and government leaders.

TBR has tracked developments in the region through special reports on Egypt and other nearby countries and IT services vendors’ investments as well as the financial and performance metrics of management consultancies published semiannually in TBR’s Management Consulting Benchmark.

Mavenir ready to prove it is possible to transform mobile network economics

TBR perspective  

Mavenir’s message is resonating with the market, and its reputation among CSPs is strengthening. In a few short years, the upstart vendor has gone from an M&A amalgamation of disparate businesses to a cohesive, relevant vendor that is now being considered alongside incumbent Tier 1 network vendors for projects at leading CSPs worldwide.

Mavenir is a legitimate contender to supply solutions that will comprise the new webscale-like network architecture CSPs are eager to implement to stay competitive and participate in new value creation in the digital era. The vendor’s greenfield play to provide cloud-native solutions is unique and is a key differentiator from incumbent OEMs that continue to push their relatively expensive, inflexible and closed systems. CSPs are intrigued by Mavenir’s virtualization offerings, not only with the low price points and total cost of ownership (TCO), but also with the performance of their systems in trials and now, with vRAN in some select commercial production environments.

TBR believes Mavenir will become one of the leading telecom network vendors in the digital era and will take measurable share from incumbent vendors during the 5G network build cycle, not only in RAN, but also in the mobile core and digital enablement-related platforms. Though Mavenir is a small fish in a sea of goliaths, the company is able to hold its own by trumpeting its software-first mantra as a means of redefining mobile network economics.

Mavenir’s assessment of where the market needs to go is spot on. CSPs must evolve to become more webscale-like in nature, adopting a network architecture that is dynamic, agile and able to support the demands of the digital era as well as new business models that can be scaled and supported at fundamentally different economics compared to the traditional architecture. More of the same will not work anymore, and CSPs must think and act differently to stay relevant and profitable in the digital era. CSPs are intrigued by the claims Mavenir is making pertaining to radically different mobile network economics and there is desire among CSPs to hear from the vendor about how it can deliver on those promises.

TBR believes Mavenir’s biggest, most impactful play is in the RAN space, which is an approximately $40 billion market and is ripe for significant disruption. RAN is the domain that will be the catalyst to transform Mavenir from a relatively small vendor by revenue (around $500 million this year) into a multibillion-dollar global powerhouse.

Mavenir provided a corporate strategy overview and updates on each of its business units at its third annual analyst day. The vendor is well aligned with underlying trends in the telecom industry, particularly network virtualization and open infrastructure. Mavenir now claims to have product offerings across several network infrastructure domains, including RAN, mobile core, IMS (particularly, VoLTE and RCS), Unified Communications & Collaboration (Mobile Business Fabric), network security and digital enablement platforms, such as for private networks, OSS/BSS and mobile advertising (Aquto). The company’s software-first, hardware-agnostic approach is timely as communication service providers (CSP) accelerate their transformations into digital service providers.