The Much Misunderstood Larry Ellison

It is not often I rally to Larry Ellison’s defense.  In fact, it has never happened, unless you count that incident involving two underage interns, the failed MiG fighter acquisition and ten thousand cubic yards of Jello, but the legal settlement thereof bars further elaboration.

Larry recently made a statement which people are assuming is just a typical, cynical, self-serving, Machiavellian exercise in spin and depositioning as befits a disciple of Sun Tzu and Miyamoto Musashi (bonus points for the commenter who can connect the advice of either of those strategic gurus with dumpster diving).

But what if he actually spoke the truth?  Past performance admittedly might lead you to overlook such a possibility, but Larry’s comment came during Oracle’s quarterly earnings call with financial analysts last month.  It slipped out in the midst of the ritual competitive bashing, in this case of SAP’s new midmarket offering, that Oracle uses to distinguish its conference calls from those of other publicly traded companies:

“So while we think it’s an interesting market — the small market — because it’s large, we just haven’t figured out a way to make a substantial profit in that market. We think it’s hard to make money. Our strategy: add more value, go upstream, sell industry-specific software to our existing customers, and we’ll watch and see how SAP does going after small companies. Especially with in Software as a Service which we think is very interesting, but so far no one has figured out how to make any money at it.“

Focus on the last line about the bottom line where Larry questions whether people can make money off of SaaS in the SMB market.  The SaaS euphoria has been driven largely as a technical imperative by enthusiastic new market entrants.  The SMB market has been held up as a green field that lets providers sidestep the myriad complexities of the enterprise.  And there is no doubt this is a vast and underserved market that would love to eliminate the hassles of deployment and operations.

But what about the profit opportunity?  Now Oracle is a company run by investment bankers these days, but it is a company that banks serious profits – over $4 billion last year with net margins approaching 25%.  When they look at business opportunities, they are looking for big profit pools.

Larry Dignan at ZDNet jumped in and channeled his namesake:

What Ellison could have said [is that] no one has found a way to make gobs of money in SaaS. Salesforce.com is profitable but you could find the $481,000 the company made in its latest fiscal year in Ellison’s couch. Indeed, without maintenance fees SaaS may be less profitable in the long run.

…

However, Ellison can make these comments precisely because Oracle has its SaaS plan ready–it’s called NetSuite.

I think he was a lot closer with the first paragraph than the speculation in the second paragraph.  Larry does have a personal investment in NetSuite that is raising interesting questions as NetSuite tries to go public, but I believe that is irrelevant.  No matter how you look at it, a subscription-based SMB-focused SaaS model at scale looks like a tough business model.  NetSuite certainly has no solution to the financial challenges as we’ll see below.

Nick Carr also noticed Larry’s comment in a good piece on the shifting sands of enterprise software although he displays less than his usual level of certainty:

How will the competition play out? I wish I knew. There are at least two unknown variables: the speed with which the SaaS model penetrates larger companies, and the ultimate profitability of the SaaS model. There are some indications that the adoption of SaaS is advancing more quickly than expected, but there are also indications that the hype may at the moment be getting out ahead of the technology. As for profitability, about all we can say is that Ellison is probably right: SaaS is unlikely to be as lucrative as the old licensing model that it’s replacing – which happens to be very good news for customers.

Profitless prosperity may be great for customers, but at some point companies and their investors will have to find some profits or the activity will come to an end (unless you’re in the airline business).

ART OF WAR OR JUST ACCOUNTING?

That was a really verbose motivation to take a look at Salesforce.com’s financials and make a prediction about their stock price direction.  As the SaaS poster child, they offer some interesting lessons in the search for potential profits from SMB SaaS.  My conclusion is that the poster child’s economics are not only not the shining beacon for the industry you’d expect but actually a disappointment.  Lets go to the numbers:

• Revenue: $613 million over the last four quarters.  Up from $497 million for the last full fiscal year (we’re half way through the latest fiscal year), which in turn was up 60% on the prior year.  No doubt Salesforce has been a great revenue growth story.
• Earnings: $8.17 million over the last four quarters, up from Dignan’s $481,000 in couch money for the last full fiscal year (but below 2006’s $28 million).  They’re not doing a great job turning that revenue growth into profits, and this is a company that has been around since 1999.
• Interest income: $22.43 million in the last four quarters, which is nearly three times the company’s overall net profit in the same period.  Hmm…
• Valuation: Salesforce has a market capitalization of over $6 billion as I write this and trades at a forward P/E of over 500.  That valuation is supported by less than a million dollars per month of profit and no profit if you take out interest income.  Wall Street has some mighty big expectations for future profits.

So where will those profits come from?  The problem is there is a giant sucking sound on the income statement that exerts massive drag on profits: sales and marketing which is a proxy for what it costs to acquire customers.  Bruce Richardson at AMR computed the numbers:

Over the last six quarters, salesforce.com has spent between 49.7% and 51.1% of revenue on sales and marketing.

NetSuite is no better  and could be worse, again from Bruce Richardson:

As NetSuite’s Zach Nelson pointed out in The Wall Street Journal (September 19, 2007), even with free trials, it tak
es two months and three to five product demonstrations to close a sale. He was quoted as saying, “It isn’t easy to figure out how to acquire customers and keep them happy at a low enough cost that you still earn healthy margins.”

A cursory review of NetSuite’s financials in their recent S-1 filing to go public shows they lost $23 million on $67 million in calendar 2006 and while they have a nice revenue hockey stick over the last three years, the profit line is borderline horizontal and well below the x-axis (i.e. in the red).  They also call out explicitly the challenges of SMB customer acquisition:

Our customers are small and medium-sized businesses, which can be challenging to cost-effectively reach, acquire and retain.
We market and sell our application suite to SMBs. To grow our revenue quickly, we must add new customers, sell additional services to existing customers and encourage existing customers to renew their subscriptions. However, selling to and retaining SMBs can be more difficult than selling to and retaining large enterprises because SMB customers:

• are more price sensitive;

• are more difficult to reach with broad marketing campaigns;

• have high churn rates in part because of the nature of their businesses;

• often lack the staffing to benefit fully from our application suite’s rich feature set; and

• often require higher sales, marketing and support expenditures by vendors that sell to them per revenue dollar generated for those vendors.

If we are unable to cost-effectively market and sell our service to our target customers, our ability to grow our revenue quickly and become profitable will be harmed.

The subscription model Salesforce, NetSuite and many other SaaS vendors use is extremely sensitive to the interplay between the cost to acquire a customer (which is an up front cost before you see any revenue), the average revenue per user (which dictates how long it takes to pay back the up front cost, never mind COGS and overhead) and the rate of churn (which tells you how many customers will stick around long enough to pay back the up front cost).  Small deltas in these numbers can make a big, big difference in terms of profitability.  Vonage is a great example of what happens when those numbers don’t add up harmoniously.  And these parameters are interdependent.  Raising prices likely increases churn, for example.

One argument to support Salesforce’s valuation is they are a young company that is investing for growth and just need to get to scale for their business model.  The difference however is they are not like the traditional software company trying to grow into a relatively high, relatively fixed R&D budget where above some threshold additional revenue falls largely to the bottom line.  Salesforce spends relatively little on R&D and their capex on infrastructure is surprisingly low.  The issue is their sales and marketing cost which seems to scale with revenue.

Looking at Salesforce’s future, they face a couple challenges.  Revenue growth will continue to slow.  It has been slowing for five years.  It is always harder to sustain your percentage growth on a bigger base.  And with minimal profit growth, revenue growth seems to be the proxy for the sky-high multiple, and assumes a big profit payoff is coming some time in the future.

They also will face intensifying competition.  Microsoft will soon offer a hosted version of Dynamics CRM, which has only been available as an on-premise offering to date.  The product offers native Office and Outlook integration, deep customization  and broad partner support.  SAP and Oracle are also peripherally in this market, although both have pricing above Salesforce and haven’t really been serious to date about the SMB CRM market.  There also are other startup competitors like NetSuite.  Competition can impact the key variables in a couple ways, all negatively:

• Acquisition cost – it is likely to cost more, not less for Salesforce to win a customer in the face of more competition.  Today Salesforce spends over $700 to acquire a new user.  Competitors like a Microsoft or an Oracle may have a structural advantage in terms of acquisition costs because they are global players with an instantly recognizable brand who can spread their sales and marketing investments across both on-premise and SaaS deployment options for their software.
• Average Revenue Per User – competition also tends to reduce prices.  Microsoft’s pricing of $39-59/user/month for the SaaS version out of the gate will undercut Salesforce’s approximately $71/month in average revenue per user. 
• Churn – when customers have more choices, they’re more likely to go somewhere else.  Today Salesforce needs about ten months to pay off the initial acquisition cost of a subscriber.  When you add in COGS, R&D and corporate overhead, it is more like 18 months.  And unilateral competitive spite gestures on par with cutting off the nose to spite the face probably don’t help on the churn front either (see The Fat Guy‘s blog).

Small perturbations in these parameters can have a huge impact on the attractiveness of the model, and it is easy to see downward pressure on all of them.  It is hard to see how Salesforce can reduce their marketing spend as competition heats up unless they want to stop growing.  So what happens?

• Salesforce will continue to pursue more “enterprise” customers and try to move up market.  Their average seat size per deal has almost doubled in the last five years and a very small number of customers (<100) may account for upwards of 40% of their seats.  The enterprise may prove a more cost effective marketing environment, but it also brings with it many more requirements and competition (in their favor, one of those competitors is Siebel, now owned by Oracle, who have the least satisfied customers I have ever seen).
• Salesforce will continue to push their platform strategy.  It is a nice story, but it hasn’t contributed any discernable network effects to date that reduce acquisition costs.  But they seem to be doubling down that it might, suggesting a lack of other promising strategies.
• You will see serious multiple compression for Salesforce (meaning their stock price goes down).  Baring some kind of miraculous breakthrough in terms of a more efficient marketing model for the SMB market, slowing revenue growth without any concurrent growth in profits is going to squeeze the stock.  Going from an insane forward P/E of 500 to an almost-as-insane 250 means the stock halves.  But the reality is when the sentiment flips, the compression is likely to be more extreme.  I think the stock hits the wall in the next 9 months (and the company likely will continue to see good revenue growth in that time).  The frenzy of insider selling suggest this possibility may not lost on management.
• Salesforce will try to sell out and the challenge for Marc Benioff is the timing.  They simply can’t get to the scale needed to be a viable, standalone, long-term company on their current path with their current scope.  Most of the buyers probably understand that even with sustained revenue growth, in the absence of commensurate profits emerging, the company will likely get cheaper over time.  So who might be a buyer?  Some say Google but Salesforce’s inefficient, unautomated mark
  eting model is anathema to Google’s economic model.  My best guess, to bring this now way-too-long post for the three readers still with us full circle, is none other than Larry Ellison, who was perhaps being both truthful and crafty in his comments far above.  He once said of the old Computer Associates: “every ecosystem needs a scavenger”.  That idea evidently grew on him and he’s made it the strategy at Oracle, spending tens of billions to roll up business applications companies, where they can jack up and harvest maintenance revenues from relatively price-inelastic customers and cross-sell across the installed base.  It is a strategy fundamentally based on leveraging their sales and marketing model.  Buying Salesforce would give Oracle a more powerful CRM franchise than the legacy lineup they have today.  It would give them a stronger SaaS offering in addition to their on-premise offerings, although they would not have the advantages of a single code base for both deployment models unless they packaged up Salesforce to license to others to run.  They could continue to push Salesforce up into the enterprise market or use their existing marketing machine to at least sell into the mid-market.  And if the platform play starts to kick in, Salesforce does run on the Oracle database (unlike, ironically, some of Oracle’s other SaaS offerings…).  Obviously Benioff goes way back with Ellison, who had an early investment in Salesforce.  If Tom Siebel can be welcomed back to the Oracle mothership, so too can Marc Benioff.  Just a matter of the right price.

Disclaimer: I am not a financial analyst, don’t play one on TV but do think the above prediction is far more probable than some of the things that have surprised the best and brightest of the financial analysts of late.  I have no positions in CRM or ORCL.

(Image copyright The Cartoon Network)