Why Your Future Depends on Open Source — Part 2

“Will software be a business that generates a lot of profit in the future? Is open source essentially a disruption that will cause the software business to be less profitable? ”

                        — Steve Ballmer, addressing an audience of financial analysts, July, 2004

Let me end the suspense, Steve, and offer the answer: “Yes.” The software business will be less profitable in the future — much less profitable.

The enterprise software business is changing dramatically and tomorrow’s industry will look very different to today’s. The converging impacts of slowing growth, competitive pressures, and more demanding customers will cause a splintering of today’s monolithic industry offerings — and in a surprising turn of events, the software industry of the future will look much more like the open source software industry of today. But what will that mean for you, the software user?

Some of this pressure will be caused by open source itself. Obviously, if an inexpensive alternative is available, it’s harder to charge premium prices for a good or service. I liken it to bottled water — if you’re dying of thirst in a desert, almost any price for water is acceptable. You’d pay a hundred dollars for a bottle of Perrier. If you’re standing in your kitchen and water is freely available from your tap, though, there’s a limit you’ll pay for the convenience and putatively higher quality water available in a bottle. Open source has the effect of serving as the kitchen tap — and putting a ceiling on the acceptable price for proprietary software. I addressed one example of this issue in a recent blog posting.

However, even more damaging than the price pressure of open source is the impact it will have on marginal profitability of software companies. Software is an unusual — even unique — good, in that it costs practically nothing to manufacture. All the expense is in creating it; a CEO of a software company I once worked for described software companies as looking like they are all fixed costs, since there are practically no variable costs of manufacture.

The implication of this is that once your fixed costs (principally headcount) are covered, nearly all your additional revenue drops to the bottom line as profit — but every copy you don’t sell trims your income statement by nearly the entire price of the software. So every piece of software that an open source product displaces disproportionally harms the profitability of the vendor of the proprietary counterpart. So, as an example of this, every copy of OpenOffice that goes into use costs Microsoft around $300 in profits.

Consequently, it’s clear that open source will have a significant impact on the profitability of the software industry. But it is far from the only trend that is harming software profitability. Just as troubling to the industry is its lack of growth — which will have, perhaps, even more impact on profits than will open source software.

The evidence of poor growth is everywhere. In a recent presentation, IDC forecast software sales growth of around 5% for the next few years; this is a far cry from the heady days of 30% industry growth of the 90’s. Software has suffered the ultimate indignity of being dropped from growth-oriented mutual funds, sure evidence that the tide has turned on software sales. 

This lack of growth has the effect of making software companies desperate for sales. Interesting evidence regarding this desperation became public during the Department of Justice hearings on the Oracle acquisition of PeopleSoft. Testimony revealed that Oracle offered discounts of 90% to seal deals against SAP and PeopleSoft. 

Clearly, going forward, there’s less revenue dropping to the bottom line from sales — which is bad news for software company executives. After all, you don’t get those juicy stock multiples that accompany growth stock-like profitability if your net profitability is shrinking.

Between commoditization by open source and reduced revenues due to discounting, the top line is looking weaker, resulting in lower net margins. So what’s a poor software company to do?

Well, one obvious option is to use financial engineering to increase profits. This is a common tactic in slow-growth markets — merge two companies and increase profits by maintaining the existing revenue stream while trimming common functions like finance and HR, while. This tactic drove Oracle’s PeopleSoft acquisition.

Say what you will about Larry Ellison — he’s a very sharp operator. When he recognized that the software industry has a slow-growth future, he changed Oracle’s strategy from license sales at any cost to milking the installed base — sorry, moving to a subscription business model. This model allows Oracle to continue to achieve its traditional profitability via 85% gross margins on subscriptions. It’s really quite brilliant; growing the installed base via acquisitions allows him to grow profitability through ongoing maintenance fees, something Computer Associates discovered 20 years ago.

There’s only one problem with this strategy if you’re a large software company. There aren’t that many targets large enough to make your earnings grow sufficiently to keep those growth stock price-earnings ratios extant. It gets harder and harder to, as they say, move the needle.

So, what’s your next tactic to keep earnings up? It’s obvious, really. You reduce costs. We’ve already started to see that happen in the software industry. In a widely noted move a couple of years ago, Microsoft cut health care benefits, shortened vacation time, and reduced the stock purchase plan discount. 

We’ll see more of this in the future. Large software companies will nip benefits here and there, all in an effort to trim employee costs, which, as already noted, account for almost all the ongoing costs of a software company.

However, if you’re a software company, there’s a limit to this tactic as well, particularly as your business depends, relatively speaking, on happy, motivated employees.

The next tactic to increase profits is one that will directly affect you, the end user. Instead of today’s bundled, monolithic product, software vendors will move to selling an unbundled product, charging for things that currently are thrown in with the license fee.

What will this look like?

There will be far fewer services available at no cost to customers. Today, if you are a large user and are considering purchasing a package, there is no end to what the vendor will do for you. Want a product overview and roadmap presentation? The sales rep will be glad to bring a team to your site for a meeting. Want to understand how the product will integrate with your existing infrastructure? How about a proof of concept that the vendor will help build at no cost to you?

But when there’s far less revenue available through a license fee, all those free services will go out the window. They’ll all be available, alright — for a fee. Get ready for a future in which you’ll get far less personal attention from the vendor and in which you’ll have to take on more responsibility for decisions or, at least, expect to pay for advice to help you make decisions.

In other words, the software industry of the future will look a lot like the open source industry of today. Cheap (or free) software, but more responsibility for the user.  Which is the second reason your future depends on open source. Your organization will increasingly need to do more research, make more vendor-independent decisions, and implement more community-shared systems. You need to start sharpening your open source skills if you want your organization ready for the software industry of the future.