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The state of cloud profitability has never been stronger

More than a decade after taking a leap of faith, cloud vendors prove profit possibilities

For vendors such as Microsoft (Nasdaq: MSFT), Oracle (NYSE: ORCL) and SAP (NYSE: SAP), offering cloud solutions required them to leave the safe and profitable confines of their traditional software businesses, where they were confident in the business models and drove consistent double-digit operating margins. Even for born-on-the-cloud companies such as Salesforce (NYSE: CRM) and Workday (Nasdaq: WDAY), the lack of short-term profit required them to adjust funding requirements and sell this new business model to potential investors. All vendors that chose to participate in the nascent market had to take on the cloud financial risk without a clear picture of when or how their businesses would reach sustainability and profit.

More than a decade after the initial cloud transition, nine of the leading providers in the space, which come from a variety of business backgrounds, are proving out the benefits of cloud business models. It has taken adjustments to almost every major category of financial and operational strategy, but profitability has improved significantly and is gradually approaching the levels seen with traditional software businesses. In summary, the state of cloud profitability has never been stronger.

Graph showing cloud operating margin for 2015 to 2018
Figure 1

Gross profit gets little attention but delivered most of the improvement to cloud profit

The direct costs of delivering a solution — and their inverse, gross profit — get little attention in the cloud business model discussion. Although shifts in sales and marketing strategy may be more attention-grabbing, gross profit and cost of goods sold have made the bigger impact to overall cloud profitability. As shown in Figure 2, the “big nine” cloud vendors have increased cloud gross margin by 5 basis points over the last three years. At 65%, cloud gross margin is still lower than the traditional software gross margin of close to 85%, but it has improved significantly for the cloud businesses. The improvements have been driven by a variety of factors, most notably:

  • Increased scale of data centers: For IaaS vendors that own and operate core data center locations and infrastructure, their growing scale has led to greater cost-effectiveness. The cost of IT infrastructure has gone down, and automation allows vendors to operate data centers more efficiently. Additionally, there is a greater availability of third-party services such as colocation, which allows cloud providers to cost-effectively scale to new regions and expand capacity.
  • Professional services cost declines: As vendors across all cloud service types initially rolled out their services, most of the professional service needs were met by the providing vendor out of necessity. However, as these platforms and services have scaled, the level of third-party skills has expanded, shifting a lot of responsibility and opportunity for service engagements away from the cloud vendors. The result has been a shifting of professional service opportunity to the partner ecosystem, allowing cloud providers to focus on the higher-margin cloud solutions.
  • Declining acquisition-related costs: Acquisitions played a large role in the establishment of cloud computing leaders. IBM (NYSE: IBM) buying SoftLayer, Oracle purchasing NetSuite and SAP buying SuccessFactors are just three examples of the purchases that have shaped the market over the past decade. Many costs of those purchases are borne out in the acquiring organization’s cost of goods sold. As the scale of cloud businesses has grown following the large acquisitions, the overall gross margin has rebounded.
Graph showing cloud gross margin from 2015 to 2018
Figure 2

Cloud marketplaces are small in revenue impact but mighty in market impact

Cloud marketplaces are more of a slow burn compared to pronounced market impacts in books, retail and music

To predict the impact of cloud marketplaces, it is worth evaluating how similar changes in go-to-market strategies have impacted other markets. Sears (Nasdaq: SHLDQ), Amazon (Nasdaq: AMZN) and Apple (Nasdaq: AAPL) are three very different companies that illustrate just how profound an impact sales motions can have. Sears rode the impact of its mail-order catalog for nearly 100 years in a wave of success that only recently petered out. Amazon and Apple have much broader business strategies, but both owe a considerable amount of their success — which has them jockeying for the title of the world’s largest company in terms of market capitalization — to their selling methods. Both Amazon and Apple entered well-established markets and disrupted them, not by competing on the merits of their offerings but by challenging the existing sales motion with a marketplace approach. Amazon’s online approach to the book market is a very pronounced example of marketplace disruption, as Figure 1 illustrates. Amazon began selling books online in mid-1995, overtook traditional market leader Barnes & Noble less than eight years later, and subsequently expanded and dominated the market. Today, Amazon controls over 50% of the total book market in the U.S., including both physical and digital titles.

Market overview: Online marketplaces, where customers can browse, search and then buy or subscribe to software titles, have been around for quite some time. Salesforce (NYSE: CRM) rolled out the first cloud app store in 2005, and a wide variety of new options have been introduced since. Despite their longevity, the impact of these marketplaces is still uncertain. Salesforce AppExchange is a standout success, but the impact is more nuanced for most other marketplaces and the industry overall. Marketplaces have not yet become a prominent distribution model for software and cloud services, but they play a niche role in overall go-to-market strategies that include traditional direct sales, partner-driven sales and customer self-service sales. Although marketplaces currently hold a small portion of overall cloud and software revenue share, trends could bolster their role in the market moving forward.

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

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.

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

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.

Graph showing Oracle cloud acquisitions, R&D investments and cloud revenue for 2016, 2017 and estimate 2018

Figure 1

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.

Graph showing SAP cloud acquisitions, R&D investments and cloud revenue for 2016, 2017 and estimate 2018

Figure 2

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.

Graph showing Workday cloud acquisitions, R&D investments and cloud revenue for 2016, 2017 and estimate 2018

Figure 3

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.

SaaS sweetens the cloud pot but requires vendors to up their ante to participate

‘Best of breed’ spawns diversity in the SaaS provider landscape

The vendor landscape may be consolidating on the IaaS side of the cloud market, but that is not the case for SaaS. Customers are most likely to increase the number of SaaS vendors utilized over the next two years, supported by a number of market trends, including new workload and feature adoption, platform ecosystems, and integrated multicloud deployments.

For workload adoption, there is a leveling of the playing field for which services customers are considering cloud as a deployment method. ERP, for example, used to lag in public cloud adoption but is now much closer to par with often adopted services like CRM and HR. Much of this increased consideration comes from enhanced comfort on behalf of customers for delivering sensitive workloads from cloud providers versus their on-premises data centers.

The other factor is the proliferation of complementary services available via PaaS ecosystems. The most tenured and largest example of this comes from the Salesforce Platform, which supports thousands of ISVs developing and selling solutions that complement and extend core CRM. Salesforce may have been the first, but other SaaS vendors, including SAP, Workday, Microsoft and ServiceNow, are taking the same approach, exponentially growing available SaaS services. The last driver is the continued rise of best-of-breed customer purchasing. For contracting and performance reasons, customers have long yearned for multivendor application environments, and now vendors are actually moving to accommodate that desire. Salesforce’s acquisition of MuleSoft and SAP’s introduction of the Intelligent Enterprise vision are the latest examples of how vendors are supporting customers in choosing and integrating solutions from numerous providers.

 

This special report is part of a series driven by TBR’s Cloud Customer Research reports, for which TBR conducted more than 50 interviews and 200 surveys. These special reports will highlight key trends and topics impacting the cloud industry.

SaaS sweetens the cloud pot but requires vendors to up their ante to participate

Despite the simple graph in Figure 1 depicting SaaS market size, the space remains difficult to sum up. In the eyes of customers, SaaS options are proliferating and spanning a wide swath of business functions and stakeholders. Yes, SaaS is the largest segment of the “as a Service” cloud market—and yes, it will continue to expand. Beyond that, however, SaaS will remain a collection of separate markets, with most vendors specializing in one or two core and adjacent areas, instead of one unified opportunity. Some examples of this fragmented and overlapping landscape include Microsoft leveraging collaboration dominance to reinvigorate its CRM strategy with cloud delivers, SAP returning its focus to SaaS CRM after ceding the market to Salesforce, and Workday investing to build out a financials-focused SaaS business from its HR roots.

The market behaves in contrast to the IaaS market, which is highly consolidated around a standard set of often interconnected services and a small collection of vendors. In the SaaS market, growth will be achieved by new vendors addressing new workloads and features. From a vendor standpoint, there will be greater presence from legacy application providers such as SAP, Oracle and Microsoft, but also plenty of room for more niche providers as functional and regional niches develop.

While SaaS will grow the overall cloud opportunity, the challenge for vendors is that the SaaS opportunity will be more difficult to capture. That is not to say the historical model for SaaS adoption will cease to exist; there will still be SaaS purchases that are driven by lines of business (LOBs), transacted with a credit card in some cases, and deployed separately from legacy systems. At least some of the growth will continue to occur in that shadow IT model. However, much of the growth will be from SaaS solutions that deliver more critical services, are procured by joint IT and LOB teams, and are tightly integrated with legacy systems. These scenarios will require vendors both large and small to up their ante, bringing more sales, integration and support services to the table to win these more complex deals.

Figure 1

Graph depicting SaaS market size by delivery method from 2017 to 2022

‘Best of breed’ spawns diversity in the SaaS provider landscape

The vendor landscape may be consolidating on the IaaS side of the cloud market, but that is not the case for SaaS. As seen in Figure 2, customers are most likely to increase the number of SaaS vendors utilized over the next two years, supported by a number of market trends, including new workload and feature adoption, platform ecosystems, and integrated multicloud deployments.

For workload adoption, there is a leveling of the playing field for which services customers are considering cloud as a deployment method. ERP, for example, used to lag in public cloud adoption but is now much closer to par with often adopted services like CRM and HR. Much of this increased consideration comes from enhanced comfort on behalf of customers for delivering sensitive workloads from cloud providers versus their on-premises data centers.

The other factor is the proliferation of complementary services available via PaaS ecosystems. The most tenured and largest example of this comes from the Salesforce Platform, which supports thousands of ISVs developing and selling solutions that complement and extend core CRM. Salesforce may have been the first, but other SaaS vendors, including SAP, Workday, Microsoft and ServiceNow, are taking the same approach, exponentially growing available SaaS services. The last driver is the continued rise of best-of-breed customer purchasing. For contracting and performance reasons, customers have long yearned for multivendor application environments, and now vendors are actually moving to accommodate that desire. Salesforce’s acquisition of MuleSoft and SAP’s introduction of the Intelligent Enterprise vision are the latest examples of how vendors are supporting customers in choosing and integrating solutions from numerous providers.

Figure 2

Graph depicting the change in the number of cloud vendors utilized in the next two years

Expectation inflation raises the bar for SaaS providers

There may be a growing pool of revenue and room for more providers, but meeting customer expectations for SaaS solutions is anything but easy. Expectations have been on the rise, stoked by the greater control buyers have with cloud solutions versus on-premises software. The days of long-term software contract risk falling entirely on the customer are quickly coming to an end. Not only has the power dynamic shifted, but, as shown in the graph below, customers are successfully using more of their IT dollars to fund innovation over maintenance of existing systems. As a result, different evaluation criteria are being used for IT investments. Up front, there is a much more collaborative process between IT and LOB teams as they decide which offerings meet their underlying business need, not just what fits into their existing footprint. Calculating the benefits and return from SaaS investments is also a challenging task, as deployments use business outcomes as the ultimate goal. Although hard calculations seem challenging for most customers, it’s clear that enhanced levels of support and “customer success” roles are increasingly valued. Having these post-sale resources available and putting a greater focus on outcomes and other intangible benefits than on technology benefits seems to be the best way for SaaS vendors to meet inflated customer expectations for what the solutions can and should do for their business.

Figure 3

Graph depicting IT investment strategy of SaaS adopters three years ago versus now versus three years from now