Software, Services, and Revenue, Oh My!

oz.jpgAs much as it pains me to say this, there are some software firms out there who openly shun professional services work. Oh, they may have a small “services group”, and offer a few basic services to their clients, but they don’t really embrace the concept of professional services. Ignoring services, or not providing a focus on it, is both financially irresponsible and a strategic mistake. In Frank L. Baum’s 1900 classic tale, The Wizard of Oz, the lead character, Dorothy, was afraid of things she couldn’t see: the lions, tigers, and bears in the forest. But as you will see, there is no reason to be afraid of integrating services into your revenue streams.

Okay, I realize that the Wizard of Oz lead-in was weak – I promise that this will get better …. read on! I must apologize in advanced for the length of this article. I prefer my blog entries to have some substance to them; something you can derive value from, if you will.

When I talk about professional services from a software vendor’s perspective, I am referring to those services typically offered around the sale of a technology solution. For example, say a company buys a software package to help manage their warehouse inventories. There are potentially lots of value-added services that are located around the purchase of that software product, including, but certainly not limited to:

The list goes on and on.

It should be pretty apparent that services represents a rather large revenue universe. How big is it? According to a 2004 Gartner Group report, IT services (as a whole) encompass a $570B global industry. That’s not an insignificant chunk o’ change. Given the size of the market, and the market proximity to their own products, it’s not surprising then that many software vendors also play in the services space. As a software firm matures, the revenue from services can provide the sustained, incremental growth that software license sales can no longer offer.

As an example, consider IBM. Once known as the world’s biggest hardware manufacturer, they progressed into being a hybrid hardware & software company. They realized a long time ago, however, that once you sold that hardware and software to a customer, there was still money to be made by offering services around those products. How much cash? Today, professional services represent 50% of IBM’s yearly revenues. Even Hewlett Packard is doing $3-4B in services each year. Not shabby.

But the professional services rewards are not reserved only for the big boys. Consider The TriZetto Group, Inc., a California software & services firm focusing on the healthcare industry. Q3/2005 revenues were reported as $73.1M – which represented 261 new customer contracts. 171 of those contracts were for implementation services, software customization and other services valued at $43.8 million; 64 of the contracts were software license contracts valued at $29.7 million; and the remaining 26 were outsourced services contracts (software hosting, business process outsourcing and other services) valued at $1.6 million. So out of a total pie of $73.1M, nearly 60% of that revenue is grounded in services. Thats a big hunk of key lime, kids.

As promising as services sounds, not all software firms subscribe to the notion that offering services is the way to go. Microsoft is the biggest software company in the world. They already own 90% of practically every market they are in – the only real growth for them at this point would be in services, yet they essentially ignore it, choosing instead to allow third party vendors to provide the services instead. Simon Witts, corporate vice president of Microsoft’s enterprise and partner group, has stated publically that Microsoft is not in the services business and does not plan to become a services player. According to Witts: “We still run that as a cost center and it doesn’t even break even.”

I am familiar with one particular technology firm that has a presence here in Atlanta (we’ll call them Acme Corporation, for the sake of discussion). The Acme CTO actually argued, in the board room, against professional services. This despite the fact that professional services around their product line represented 15-20% of their overall revenue streams ($30-35M out of their total revenue pool of around $200M). The CTO basically wanted to divest the services group, in favor of outsourcing to partners. He basically lobbied to throw away a profitable $30M division of the company. His argument? “We’re a software company, not a services company.” Holding this sort of philosophical view on professional services is something akin to winning the lottery and refusing to pick up the check because you prefer direct deposit.

If you compare the Acme numbers to the Trizetto Group (mentioned earlier in this article), the overall revenue numbers are very comparable (compared at the quarterly level). The software/services mix is flip-flopped, however, even though the two companies offer similar sets of products and services, and in the same industries. Trizetto is doing 60% in service revenue, while Acme is doing only 15-20% in services. Trizetto realizes that services is an incremental way to build revenue, thus, they focus on it. Acme doesn’t – hence, their CTO lobbies to not offer any direct services at all. Call me crazy, but I want to buy stock in Trizetto.

Trust me when I say that shareholders could care less about where your revenue originates. As long as the revenue is around the core competencies of the firm, then let the good times roll.

Another smaller, but fast growing, software firm in Atlanta also held the same view – clinging onto the belief that they were purely a “software” company, and not a “services” company. Their problem is a little different. They “like” the concept of professional services, but are absolutely insistent that their software sales be higher than their services sales, irrespective of how much services work they leave on the table. This makes absolutely no sense whatsoever. If I had shares in this company, I would have sold them immediately after hearing about this. This is not a company that is positioned for long-term success (and indeed, I now understand why they are struggling to compete in their sector). You may build a company on software, but you grow it on services – this particular firm has historically failed to see this, and has paid a hefty price for it through the loss of market share.

There can exist what I call a perpendicular correlation between software & services (particularly implementation or integration services). If you have a software product aimed at vertical markets, services can allow you to not only get deep vertically, but also to extend horizontally, and go into other verticals with your product. On the other hand, if you have a software product that spans horizontal markets, services will allow you to not only continue branching out into additional vertical markets, but also to go very deep within your existing vertical markets, to add additional value to your customers through niche integration. So, you determine where you want to expand and use services as a way of getting you there – a vehicle, if you will.

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Atlanta-based Witness Systems is another classic example of a software company that seems to “get” services. In 2004, 51% of their revenue was derived from value-added services offered around their software products. From their 2004 annual report:

Services revenue, consisting of installation, training, consulting, maintenance support and reimbursable travel expenses, increased 35% to $83.7 million in 2004 compared to 2003 and 80% to $61.8 million in 2003 compared to 2002. These increases were primarily due to the installation and training services related to new product sales and due to customers renewing their maintenance contracts with us thereby increasing our recurring maintenance revenue stream.


Another big gap that I seem to see in a lot of firms is the lack of focus on training & development services. Contrary to what some software executives believe, this is big business! A colleague of mine runs a very profitable training and development group in a mid-size software firm. He routinely attains profit margins of 50-60%, yet has his budget slashed early and often. This is probably attributed to lack of education (ironic, I know) on the potentials of training services, or again, executives misguidedly clinging to the belief that to survive they have to sell more software licenses than anything else. Executives would be wise to wake up and realize that by not focusing on customer assimilation with their products, that they are leaving even more money on the table. The offering of training and assimilation services should be viewed as an strategic investment for a software firm, not treated as merely a cost of doing business.

So it is clear that services is an incremental revenue builder, and is a critical cog for strategic planning. Why, then, are so many software firms not pushing services? After all, they own their products – as such, they are the best providers of related services. By allowing others to offer those services, these companies are simply leaving money on the table.

Perhaps it is that these software executives don’t really understand how to create, nurture, and ultimately grow a services component to their organizations. Having played on both sides of that equation, I can personally attest to the differences. In cases such as this, management needs to focus on the problem, and bring in someone who can help them realign themselves accordingly. Ignoring a deficiency in your services strategy is not a viable answer. Firms that ignore services, and continue to stay on the “software-only” track, will eventually find themselves on the outside looking in. Further, those companies that philosophically fail to get over the “we’re a software company” mentality will suffer the same fate.

Those software firms who continue to shun services are going to face continued revenue expectations, and will be forced to adjust their service mix in their overall business, which will invariably put pressure on their margins. The integration of end-to-end solutions – the complete solution, if you will – is driving customer acceptance. This will force those service-shunners to scramble for alliances to do their bidding, which will result in more money being left on the table, and an increased risk profile for each engagement, as there will be a reduction in control.

Technology buyers want the full solution. They don’t want to piecemeal their critical systems by working with 5 different vendors (software, implementation, training and development, help desk, etc.). The competitive advantage has historically fallen, and will continue to fall, to those vendors that can see beyond a simple software sale, and provide value around the solution itself. Doing anything else, quite frankly, is not only leaving money on the table, but leaving tasty scraps for your competitors.

I won’t even get into the fact that the single biggest movement right now in the software sector is the open source movement – and open source businesses are essentially services plays. Even venerable firms like Apple are now seeing the value in this and jumping on board. I promise to get on that horse another day.

Cheers.

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