Competition keeps SaaS profits artificially low

More software-as-a-service vendors are entering the market and the competition has led to profits being sacrificed for customer acquisition and to expand product offerings.
Written by Kevin Kwang, Contributor

Rising competition in the software-as-a-service (SaaS) market means vendors are focused on getting more customers onboard and improving their products, instead of paying attention to their profit margins.

Sabharinath Bala, research manager of enterprise applications at IDC Asia-Pacific, pointed to the increasingly big traction for SaaS-based products in the market which has resulted in significant top-line growth for the vendors. This is especially so in the small and midsize business (SMB) segment which has enticed major players to plunge into this space, he said.

While we do incur incremental hosting costs when delivering SaaS solutions, we tend to see other costs such as marketing come down. 

- Intuit spokesperson 

"Unlike traditional on-premise solutions, SaaS offerings have much higher operating costs as percentage of revenue, which has resulted in diminishing the profit margin for the SaaS business model," he said.

This was something Canalys President and CEO Steve Brazier highlighted. He said there is a lot of hype in the cloud market currently but the contribution of cloud to the overall IT spend globally is expected to reach only 8 percent in 2013. Furthermore, poster boys for the cloud industry such as Salesforce.com have not been profitable, Brazier noted.

Profitability not immediate concern
Jillian Mirandi, an analyst at Technology Business Research (TBR), said SaaS companies are talking up revenue growth and projections during earnings calls and in their financial reports because these are areas they are emphasizing. 

"The companies focus on bookings growth and cash, and then invest everything they can back into the business to drive further growth," Mirandi stated. "In the fast-growing SaaS market, vendors want to expand their customer footprint before their competitors do."

She noted the cost pressures on profit margins are inevitable. Delivery costs, whether in terms of buying physical hardware or renting data center space, is expensive for new SaaS vendors and the cost goes up based on the customer base. This makes delivery and sales more expensive in the SaaS model compared to traditional software licensing, the TBR analyst explained.

The cost is felt more by traditional software companies branching out to SaaS-based delivery since they are essentially cannibalizing their core businesses. "However, the choice is either cannibalize yourself, or become obsolete eventually," Mirandi said.

Financial software provider, Intuit, is one vendor that has ventured into the SaaS business model, but it downplayed the additional costs it has taken on. A company spokesperson told ZDNet Asia: "While we do incur incremental hosting costs when delivering SaaS solutions, we tend to see other costs such as marketing come down.

"We've said that we think we can maintain our gross margin as we continue growing our SaaS customer bases, so we don't expect meaningful cost pressure from the move to SaaS," he said. Venturing into the software-as-a-service market also has enabled Intuit to expand its market opportunities and grow new customer bases, he added.

Another cloud-based financial software provider, Intacct, argued against any notion SaaS is not a profitable business because of the low margins shared by big players such as Salesforce.com.

Company CFO Marc Linden said: "In short, this is an overly simplistic view of SaaS companies. The payments for service are spread over time. In other words, the customer only has to pay as they receive benefit from the service, so SaaS vendors have a large upfront cost of customer acquisition which is not immediately offset by revenues."

The current profitability of a SaaS company may also look artificially low if it is acquiring a lot of customers, Linden noted. As more companies switch from traditional software licensing vendors to SaaS, vendors in the latter camp are growing rapidly and this has impacted their short-term profitability, he said.

The market is certainly growing quickly to justify the assertions of both Intuit and Intacct. Gartner in March noted SaaS revenue in Asia-Pacific alone is expected to jump to US$934.1 million in 2012, up from US$730.9 million in 2011.

Globally, the SaaS revenue will expand 17.9 percent to hit US$14.5 billion, up from last year's US$12.3 billion.

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