SaaS cloud pricing: Can it ever add up?

Summary:Vendors of software as a service aren't making money. So what will happen to SaaS pricing when they decide to try and turn in a profit?

It's easy to see the appeal of software as service. Organisations like its relative cheapness and apparent flexibility. But some are now asking how long those advantages can last and are recognising the risks in browser-based short-termism.

"SaaS pure-plays and those who are moving to a SaaS model, they're not pulling the profits and many of them can't see when they are going to. So a change has to come" — Angela Eager, TechMarketView

The SaaS market appears to be in rude health. Analyst firm Gartner reckons spending on SaaS will hit $22.1bn in 2015, up from $14.5bn in 2012. Yet SaaS vendors aren't making money, according to Angela Eager, research director for enterprise software and application services at TechMarketView.

"SaaS pure-plays and those who are moving to a SaaS model, they're not pulling the profits and many of them can't see when they are going to," she said. "So a change has to come."

Eager's take is largely based on profits as defined under generally accepted accounting principles. Excluding things like stock option expenses, acquisitions and other items, SaaS vendors are profitable. Wall Street goes with non-GAAP results and would argue against Eager's take. Simply put, there's a big difference between GAAP and non-GAAP results:

Consider the following:

  • Salesforce reported a net loss for fiscal 2013 of $270.44 million, or $1.92 a share, on revenue of $3.05 billion. But when you exclude stock-based compensation, one-time tax allowances, amortization of purchase intangibles and interest expenses, Salesforce reported an annual profit of $1.63 a share.
  • Netsuite reported a fiscal 2012 non-GAAP profit of 26 cents a share on revenue of $308.8 million. Including stock options and other charges, Netsuite reported an annual loss of 50 cents a share.

Eager does not believe that the lack of SaaS profits is because providers are in an investment phase and just covering their upfront infrastructure investment costs.

"It goes deeper than that. If it was just upfront costs, maybe it would be easier to predict when you would hit that upfront profitability. From what I can see, a lot of the vendors are just not able to," Eager said.

According to Eager, we are in a period of the market where the traditional drive for profitability is not seen as a priority. "But that point is going to come and it may not be too many years away," she said.

Focus on acquiring customers

SaaS vendors are clearly focusing on the acquisition of new customers, rather than profits, according to Ovum principal software analyst Roy Illsley.

"SaaS at present is still doing a bit of a land grab," he said. "It's still getting people to use its services with the view once you're hooked up and using them, your exit strategy is pretty minimal — you can't really go anywhere, can you?"

Illsley also thinks that sheer volume of new customers will help providers move towards profitability.

"As they get more and more people using their services and their servers get utilised better, then their per-unit costs on that side will come down and their profitability will increase," he said.

But Illsley argues the mechanism will only go so far to making SaaS vendors profitable. "That's only going to go part of the way. It obviously depends on what their infrastructure and hosting arrangements are like," he said.

"If they were a very efficient operator that scaled their operations to meet the demand and they sweat their assets as much as they can, it's not going to be great for them."

Low-priced software

One of the key factors in the profitability equation is people's perception that SaaS should be low cost. Dr Will Venters, lecturer in information systems at the London School of Economics, believes that perception has its roots in consumer technology.

"The idea of the iTunes apps and the economy associated with those are so focused on low costs that we've seen a plummeting in expectations on the amount we'll spend on software," Venters said.

"The consumer of a software service is just as reliant on the provider of the software service making money as the provider is itself" — Dr Will Venters

"There's become an expectation in society that software is a lot cheaper than perhaps we're used to it being."

Yet, according to Venters, at some level we have to pay for software and particularly enterprise software if it involves significant investment in its construction.

The trouble is the old relationship between the user of the software and its vendor has changed under SaaS. "The consumer of a software service is just as reliant on the provider of the software service making money as the provider is itself," he said.

"You can't have one without the other, which is perhaps slightly different from [on-premise] software where you used to be able to have escrow and you could continue to keep nursing an old piece of software even though the company providing it had gone bust — not great policy, not a great idea — but that's not the same with SaaS. You are reliant on where that IP goes."

Change in SaaS business model

So what can SaaS providers do to make those profits on which the consumers of the software unwittingly rely? TechMarketView's Angela Eager believes there has to be a change in the business model.

"That can go various ways — maybe adding additional services like the expert services is one way of going. That's inevitably going to lead to rising prices," she said.

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"Another option is obviously increasing that baseline price. But given the way that SaaS pricing is perceived, I can't really see that going down well with the customer base. So I don't think it's going to be feasible to do a straight increase. It's going to be necessary to add additional value services instead and increasing the revenue that way."

Eager also thinks the concept of paying for flexibility is missing from the present SaaS model. "You see that in other industries where you have to pay for flexibility. But it's the other way round when it comes to SaaS pricing," she said.

"If you book an airline seat, and you want flexibility in terms of the date you travel and the routing and the ability to change your flight with no penalty, you've got to pay more for it."

Along with possible price hikes in the short term, more expensive services are the way forward for SaaS providers, according to Ovum's Roy Illsley. "The long-term strategy of the SaaS providers is to get the installed base, get their costs down so they can run their operations much more efficiently and deliver the change and then upsell as they move out of just SaaS," he said.

"If you look at Salesforce, they are now platform as a service, they've linked up with lots of other people, [like] BMC Remedyforce. They're expanding, so the whole space is becoming less of an individual, isolated SaaS application that you use and more of that SaaS application being part of a platform and a bigger service. That's where you're going to find the value for the providers."

Lock-in and SaaS profits

The LSE's Dr Will Venters sees the issue of lock-in as central to SaaS vendors' profitability plans. "In SaaS you are often locked into the development pathway of the SaaS provider. You can't stick with XP the same way we all stuck with Windows XP because we didn't like Vista," he said.

"So if you're being driven along that pathway and that pathway involves a future where you're going to be paying a higher amount for software, it's very hard just to say, 'Well, we'll just stick with the legacy for a continued period until we work out what we're going to do'," Venters added.

"At some point we're going to end up with a consolidation if nobody's making any money" — Dr Will Venters

"I suspect there's some of: 'We'll drive our SaaS product in way that in the future that it becomes more locked-in for our clients and provides opportunities for us to upsell significantly."

Venters also thinks analysing their customers' usage could also be a source of profits. "The other side is the data analytics argument that says, 'We'll have products to sell by our access or our understanding of how clients are using our service' — the Facebook kind of economic model, where Facebook is not going to make money out of the consumers of its service. It's going to make money out of selling those eyeballs in some way," he said.

It may not be in the short term, but SaaS providers will need to show a profit at some point. "That they haven't got economic models doesn't necessarily mean they can't continue as long as their investors are prepared to shovel money into it," Venters said.

"But at some point we're going to end up with a consolidation if nobody's making any money. That might be the point at which we start to need standardisation because there will be companies that are left reliant on SaaS companies that are not economic. Then the price will be determined because they'll either have to decide to switch to an alternative or pay for that SaaS company to become profitable."

SaaS market slow-down

Angela Eager also believes changes to pricing are not imminent. "With any market there's going to be a limit when things are going to start to slow down. We're a long way off there now," she said.

"We're still way into double-digit growth for anything SaaS-related. So SaaS has got a long way to go, but inevitably there is going to be some sort of slow-down because it's more than just low-hanging fruit. It's the number of applications and businesses that are prepared to go that way and what type of applications they're prepared to port."

Changes to pricing and SaaS approaches may occur over a longer period, but Eager still thinks the present business model will result in short-term consequences.

"This is going to be a make-or-break year for several companies, several technologies, several approaches to the market and it certainly is potentially for some SaaS companies," she said.

"There are a lot dimensions to it. Is SaaS going to break into ERP in a serious way? Are they going to break into some sort of profitability or at least move towards it?"

Topics: Cloud, Enterprise Software, Salesforce.com, Software

About

Toby Wolpe is a senior reporter at ZDNet in London. He started in technology journalism when the Apple II was state of the art.

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