SAP-Microsoft talks underscore harsh market reality

But what was in it for SAP, the leader in the business software market, with over US$8 billion in sales? The company hasn't fully said. But one answer to that question provides some telling facts about the entire enterprise software industry.

SAP, along with rivals Oracle and PeopleSoft, has long enjoyed fat profits and double-digit growth, as large corporate customers stocked up on financial, human resources and manufacturing software--functions that fall under the category known as "enterprise resource planning," or ERP.

Last year's talks with Microsoft, coupled with Oracle's bid for PeopleSoft, indicate that new ERP sales are drying up, forcing the leading enterprise software companies to look for new markets or consider mergers and acquisitions in order to grow.

"The thing to realise is that the ERP market is a very small market," said Jim Shepherd, an analyst at AMR Research in Boston. "The reality is that the Fortune 1000 only has 1,000 companies."

Although much of the technology industry faces similar challenges, this change has been particularly harsh for enterprise software manufacturers. For three decades, the prime mover behind business software sales has been the promise of a "killer app" that can give customers new insight into their businesses, wring profits in the most efficient way and help them gain a competitive edge. That's what drove multimillion-dollar sales throughout the 1990s.

In recent years, however, many corporate customers have begun to rethink that notion, especially after the twin blows of the technology bust and the national recession forced them to live with less. Now, rather than buying more products to do more things, companies want the software they already own to more closely model how they do business.

"Every year, something new was going to come out. Now these companies are basically out of ideas," said Rick Beers, director of business process architecture at Corning, a US$3 billion manufacturing company based in New York that uses PeopleSoft's products. "We no longer need the next killer app. We've all become pretty damn smart as buyers."

It's a change that software makers acknowledge. The average deal size has shrunk, and will continue to diminish, Henning Kagermann, SAP's chief executive, told CNET News.com. "Customers are buying incrementally, related to business cases. (It's) not the big replacement of the IT infrastructure; therefore, deal size goes down," he said.

The state of the enterprise software market is reflected in sluggish sales of business applications.

SAP earlier this year managed to eke out its first quarterly rise in software license sales in nearly three years, though overall sales remain slow. Last year, its overall sales declined 5 percent, to 7 billion euros, or US$8.5 billion. SAP is attempting to make up the difference through more, smaller sales. "We have less large deals, but we have more deals," Kagermann said. "We will see some increase in deal size. But we will not see a return to the old days."

Just this month, Oracle said its applications business declined by 6 percent during the past year, even though analysts had projected growth of 10 percent. Only PeopleSoft racked up a sizable software license gain, mostly on the strength of its recently acquired J.D. Edwards unit and sales to midsize companies.

Further indications of a slowing enterprise market have come from recent moves to consolidate. Last year, Oracle launched a hostile takeover bid for PeopleSoft, which had announced just days earlier that it would acquire JD Edwards. Testimony in the antitrust trial involving the PeopleSoft takeover attempt revealed that Oracle had considered its own bid for JD Edwards, as well as Lawson Software and other companies. And in addition to discussions with SAP, Microsoft had considered an investment in PeopleSoft.

SAP, Oracle and PeopleSoft have all struggled to find new enterprise software buyers at the top end of the market: the bread-and-butter Fortune 1000 customers. Few entirely new sales of big-ticket enterprise products are made to these large companies anymore--and there are even fewer of the multimillion-dollar blockbuster deals that typified the gold rush mentality of the late 1990s.

Unlike desktop applications or operating systems, sale cycles for enterprise resource technologies are notoriously long, with customers taking 15 months or more to make buying decisions. Companies only replace systems every 15 to 20 years, according to AMR, which means that major deals are few and far between.

As Shepherd put it, "It's not a decision you are going to make in a weekend."

Enterprise indigestion
The slowdown is, in part, a product of a prolonged budget crunch in the IT market, where few companies have had the money or desire to take on expensive new projects. Over the past three years, new enterprise resource software license sales have remained flat overall, according to Forrester Research, as companies struggle to digest large purchases from the boom years.

One major problem is that most large companies that need such enterprise software--which costs millions of dollars to buy, install and maintain--already own it.

Some large sales do happen. But many are likely to be the result of one of the Big 3 ERP players stealing a rival's customer. For instance, earlier this month, SAP trumpeted a deal with beverage giant PepsiCo, which had been a premier Oracle customer.

Far more common are purchases of relatively inexpensive add-ons and additional end-user licenses to complement existing systems. It's what Tad Piper, senior analyst at financial research company Piper Jaffray, calls the "would you like fries with that" approach.

"People are not really looking for the new, new thing in software," he said.

AMR projects that new license sales will increase this year, but by just 3 percent for core enterprise resource applications, to US$15.8 billion. That's decent growth, especially compared with a decline of 1 percent in years past.

But even that modest growth projection has come into question. Technology spending in the last six months was supposed to result in new enterprise sales. Database software and integration tool sales have rebounded in recent months, but a recovery in the ERP market has not yet materialised.

"There's not a complete freeze in the ERP market, but there's certainly a stall right now," Piper said.

Enter Microsoft
All of this helps explain why it made sense for SAP to be talking with Microsoft. The proposed merger would have given SAP reach into the relatively untapped small- and midsize-business market, which all enterprise software makers covet. The theory is that unlike large enterprises, smaller companies haven't yet decided on their primary business applications.

"SAP is identified with sales to very large corporations. People associate their products and technologies as being highly complex and expensive," Shepherd said. "Obviously, SAP does not have much experience in the low end of the market with high-volume, low-cost sales--that's what Microsoft is very good at."

Kagermann has stated that a priority for SAP this year is to grow its revenue and customer base. A deal with Microsoft could have benefitted existing SAP customers, through better integration between the companies' products, and would have given SAP access to smaller customers.

"The reason for SAP to listen (to Microsoft's offer) was to see if it would bring value to our clients. The key is that there is value for both the installed base and new clients," Kagermann said.

Ultimately, a deal SAP later struck with Microsoft to cooperate on Web services and other integration technologies seemed likely to deliver at least some of the benefits of the scuttled merger--with no financial or regulatory pain.

For Microsoft, the merger discussion with SAP was driven by the company's long-standing desire to jump-start its own enterprise applications business and offset slowing growth in its traditional strongholds of operating systems and desktop software. Microsoft only recently entered the enterprise resource market and so far has concentrated on sales to smaller companies.

Documents introduced as evidence in the Oracle trial also show that Microsoft saw a deal with SAP as a way to hedge against any further incursion into its database business, should Oracle succeed in its pursuit of PeopleSoft. The company also sought to acquire SAP before rival IBM could make its own bid, the documents showed.

While Microsoft has its own problems with a maturing product line and slowing growth, the company hardly has its back against the wall. With more than US$56 billion in cash on hand and market leadership in desktop operating systems and applications, Microsoft can afford to take its time entering the ERP market, if indeed it plans on doing so.

Makers of ERP software face a different story. "They have got to have new turf to hunt on," Shepherd said.

Signs of desperation
That leads to a more troubling long-term trend that affects all the high-end software makers: a growing reliance on maintenance fees charged to existing customers to offset the dearth of new license sales. Moving further in this direction, ERP software makers have also heavily discounted licenses over the past few years, as competition for limited sales has increased. Those companies counted on deriving the bulk of their money from maintenance fees instead.

In a recent Forrester Research survey of 25 IT managers in companies with at least US$1 billion or more in annual revenue, roughly half expect discounting to continue through 2004 and in the foreseeable future.

Discounting has long been a fixture of the enterprise software business, where list prices exist only in theory. Just about every enterprise software maker cut prices during the economic slowdown of 2001 and 2002. But as spending increased in 2003, industry research shows that the discounts remained.

Increasing competition for a smaller market is one reason. Also, Oracle CEO Larry Ellison claims that part of the pricing pressure is due to speculation over Microsoft's entry into the enterprise applications market. "The moment they enter, prices drop like a rock," he said under cross-examination during the antitrust trial over his company's bid for PeopleSoft.

To buyers and analysts, it is the size of the discounts that has been most surprising, leading at least some to believe that the slashed prices signal growing desperation to sacrifice license revenue for recurring maintenance and services fees.

"Over the last two years, vendors have been offering cut-rate deals," Corning's Beers said. "You have been seeing discounts of up to 70 percent from PeopleSoft and Oracle."

Indeed, in testimony presented in the Oracle antitrust trial, which ended last week, witnesses said both companies were willing to discount software license fees by 70 percent to 80 percent--and sometimes even more--in order to land a large deal.

The percentage of SAP's total revenue made up from maintenance revenue has increased every year since 2000 and lately has greatly outpaced new software license sale growth. In 2002, SAP's maintenance revenue, at 33 percent of its overall sales, exceeded new license sales by more than US$100 million.

In 2003, SAP's software sales grew a tepid 1 percent, while maintenance revenue climbed by 15 percent, according to its annual report. By contrast, maintenance fee revenue grew to 37 percent of total sales in 2003 and reached 43 percent in the first quarter of 2004.

Oracle's ERP picture is decidedly dimmer. The company said earlier this month that new license sales for its ERP business declined by 6.2 percent in its fiscal year 2004, which ended May 31. But maintenance revenue rose by more than 15 percent and now constitutes nearly 45 percent of Oracle's total revenue.

PeopleSoft maintenance revenue made up nearly 40 percent of 2003's overall sales, and the company expects that percentage to reach nearly 41 percent in 2004.

Forrester predicts that for SAP, Oracle and PeopleSoft, maintenance revenue will remain at more than 40 percent of overall sales for the foreseeable future.

Law of diminishing returns
In the long run, analysts say, the maintenance strategy can't be sustained. If maintenance fees are providing the growth, they point out, then new sales--the lifeblood of any product-driven company--are not being made. Even worse, customers are showing signs that they will resist software makers' efforts to raise maintenance rates.

Maintenance costs have risen substantially in the past few years, and many companies see those costs as out of line with the perceived value, according to an AMR survey of several hundred corporate software buyers this year. Thirty-five percent of respondents said they will try to renegotiate their maintenance contracts in the coming year.

"PeopleSoft jacked up maintenance fees from 17 (percent) to 20 percent, and I've heard they're trying to get to 22 percent," Beers said. "Some customers will balk. Corning will balk."

Still, few companies will dump their ERP systems outright, at least until something better comes along. Given the investment in time, money and internal politics needed to buy and install an enterprise system in the first place, most companies would rather stick with their products than pull the plug.

"The thing that protects that vendor lock-in is that hell will freeze over before you get CEOs and CFOs to move on to the next great thing after spending US$100 million on SAP," said Brian Keane, chief executive of a consulting company that bears his name and specializes in business applications.

SAP's Kagermann acknowledges that advantage. "IT budgets will not grow," he said. "But the application market will grow. People want to leverage their investments. (For SAP) there is no chance to come back with the next killer app and say, 'OK, now take everything out.' No chance. People have invested too much. Clients would kill us if we came to them with a revolutionary idea. They want to (get) their bucks out of their investment."

But change is inevitable. History shows that the business software market goes through a major revision about once every 10 years.

The good news is that smart software buyers are in the driver's seat when it comes to cutting favorable deals. But remember to read the fine print, one IT manager warns. "This market is fascinating, and it's changing. Those who can figure it out are going to benefit from it. Those that can't are going to be victimised as hell."