For all the stories about declining PC sales, rise of smartphones, Web 2.0, and Cloud computing, an often missed discussion is on the other side of the industry: the computer software business. It’s an important omission as hardware without software is just an expensive paperweight. What differentiates a Windows PC from a Linux computer or Android phones vs iOS? Though there are some differences in design and features, in the end, software is king.
As a key intersection between the hardware and end user, its low scalability cost, low distribution costs, and reliance on highly educated labor, software should be a highly profitable business. However, an overview of the software industry reveals some concerns about nature of the business. From IDC, the worldwide hardware sector grew or was estimated at 13% and 7.8% for 2010 and 2011 respectively; however software grew only at 3.9% and 5.3%, significantly lower. Looking through, software can be broken down into three main categories: enterprise (logistics, automation, corporate productivity, etc), infrastructure (OS, databases, cloud, etc), and general consumer software (videogames, media players, apps, etc).
In general, enterprise software has been strong as business productivity needs have only grown as the world, supply chains, and logistics become more and more complicated. The enterprise software market was expected to hit $267 billion in 2011 and projected to grow 10% for 2012. Of this market, resource planning is the largest component at $23 billion. The enterprise software is dominated by SAP AG /quotes/zigman/126928/quotes/nls/sapSAPwith sales of $10 billion (SAP: +35% YTD) in 2009 followed by Oracle Corp. /quotes/zigman/76584/quotes/nls/orclORCL at $6 billion (ORCL: +21%). The next two: Sage /quotes/zigman/125998UK:SGE (SGE: +3.4%), and Infor (privately held), two lesser known players. For enterprise software, emerging markets are a key source of growth as many foreign companies are looking to catch up to the U.S. in productivity. IDC predictions peg emerging markets with 14% IT spending growth, three times the developed markets at 4.5%.
Infrastructure software has also been strong, largely driven by cloud computing. As per IDC, cloud spending is estimated to hit $60 billion in 2012, growing 26%. Cloud software management is expected to grow 62%, following 91% in 2011 and 109% in 2010. Infrastructure software is a slightly more crowded market than enterprise with companies such as Microsoft (MSFT: +8.7% YTD), IBM (IBM: +5.1%), Oracle (ORCL: +21%), VMWare (VMW: +2.2%), Google (GOOG: +4.5%) and others all in play. However, the two most famous names in Cloud are Salesforce.com Inc. /quotes/zigman/338061/quotes/nls/crmCRM(CRM: +44.5%) and Amazon.com Inc. /quotes/zigman/63011/quotes/nls/amznAMZN (AMZN: +37.6%). However, with cloud revenue figures not publicly available and astronomical PE ratios, assuming it had earnings (see AMZN, CRM), jumping in the cloud today is a much more risky venture than growth figures would indicate.
For many readers, the most visible side to the industry is the consumer software side which you see every time you use a device. It’s also the most varied, comprising videogames, antiviral security, media and content creation, web activities, apps, and etc. Interestingly, consumer software is by far the weakest performing. There are several underlying reasons for this shift in consumer software. A simplistic way to understand this market is to ask yourself, when’s the last time you paid for a web browser? DVD or MP3 software? Email? Look through the apps on your iPhones, how many are free? How many are 99 cents to $1.99? How much are you paying to use Youtube videos? Or Wikipedia and Facebook? For almost everyone the answer is obvious but this was not always the case. A decade or two ago, many of these were products were paid. Before the Netscape/IE browser wars, you had to buy browsers. It is no longer the case today as there are many acceptable and free alternatives to paid software such as Google Docs instead of Office, iTunes, Wikipedia, Apache, GIMP for Photoshop, the list is long.
While great for consumers, it’s a different story for companies and investors with now outdated business models. The rise of open source software and the spread of programming is a strong trend that has affected consumer software in the past and potentially enterprise and infrastructure software in the future (see Rackspace).
There are however still several companies and sectors in the consumer side that has not changed. Videogames are still based on the old model. However, a quick look at the two software giants there, Electronic Acts Inc. /quotes/zigman/71356/quotes/nls/eaEA(EA: -42.2%) and Activision Blizzard Inc. /quotes/zigman/110164/quotes/nls/atviATVI(ATVI: -12.4%) indicates longer term issues. Casual mobile games, escalating production costs, and slow core market growth are pushing changes in the gaming industry and many incumbents are likely to suffer. EA as an example has had negative yearly profits since 2008. Other companies such as Symantec Corp. /quotes/zigman/78627/quotes/nls/symcSYMC(SYMC: +17.5%), maker of Norton Antivirus, are still profitable but will suffer the same competitive issues of free alternatives like Microsoft /quotes/zigman/20493/quotes/nls/msftMSFTSecurity Essentials. However, some consumer companies are still doing well such as Adobe Systems Inc. /quotes/zigman/67665/quotes/nls/adbeADBE(ADBE: +20.3%) and Autodesk Inc. /quotes/zigman/68719/quotes/nls/adskADSK(ADSK: +6.5%) due to their focus and entrenchment in the professionals market. Long term however, these companies all face the same issues that has pushed other consumer software companies out.
Lastly, what may be a last bastion of consumer software: mobile apps, are not what they are made out to be. Various studies of mobile apps have found that for every success story, there are dozens to hundreds of failures due to problems such as escalating costs, poor visibility, and low prices. Some figures: 80% of apps only average $300, most downloaded apps are free, and sales are highly unequal with 97% of revenue going to the top 20% of developers. Don’t expect mobile apps to save the day.
With the electronics industry still growing and adoption increasing, software is still growing with it. However, growth between the enterprise, infrastructure, and consumer software sectors are unequal and several underlying trends such as open source software, web advertising, and cloud services pose a risk or boon to many of their business models. In such an environment, due diligence research is essential.
– J. Zhang
