A September 1st research report from Wedbush Equity Research argues that the software industry is already in the midst of a cyclical decline in margins and profits driven by developments in technology and that margins are going to continue to be squeezed. A quote from the introduction to the report illustrates the perspective of Wedbush analysts Steve Koenig and Kevin Takeda:
Software industry struggling to maintain their earnings momentum
“Even as software gets woven into the fabric of our enterprises, pubic infrastructure, networks, and devices, vendors are struggling to maintain their earnings momentum. Our industry analysis indicates revenue growth is slowing as operating margins have begun contracting over the last several years. We think several factors are pressuring the industry:the adoption of cloud computing; the incursion of Internet companies into enterprise computing; the consumerization of enterprise software; and greater acceptance of open source models.
The pair then go on to offer a more fundamental explanation for the gradual decline in software margins (which have been decreasing steadily since 2009). “However, these developments are mere manifestations of a more fundamental dynamic: an inexorable march towards zero marginal costs for distributing and consuming digital information.”
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Enterprise software firms facing headwinds
The Wedbush report highlights that there are certainly lots of opportunities for small- to mid-sized software firms to innovate and succeed, the same can’t be said for enterprise software firms. The analysts say that the large business customers of enterprise software firms are trying to implement technological change in communications, logistics, and manufacturing that will drive down the cost of producing and sharing a variety of products and services, but are struggling to coordinate their people, processes, and infrastructure, resulting in a kind of inertia that favors incumbent vendors. However, as Koenig and Takeda note, “the power of incumbency doesn’t last forever.”
The pair sum up their view of the future of the software industry: “In our view, the industry is changing in ways that will lead to lower overall profit margins, so investors will have to navigate a more challenging landscape to find their winners.”
The open source revolution
Open source means software that is free to use, share or modify. With open source software, vendors typically sell their services and support for the software versus charging for a software license. The category of open source software has been growing rapidly over the last few years.
Koenig and Takeda argue that although open source is just one of the factors holding back software industry growth and margins, open source is clearly seeing greater customer adoption and will soon have a major impact on commercial license sales in several categories, such as database, middleware, and analytics.
Red Hat has already created a profitable support-oriented business in the OS sector. Open source web servers such as Apache Corporation (NYSE:APA), and app servers such as JBoss are becoming standards, and nearly a dozen SQL and NoSQL open source databases are also commonly used.
That said, the Wedbush report points out that aside from Red Hat Inc (NYSE:RHT), vendors have had difficulty creating viable businesses using open source models. Koenig and Takeda say that will change in the near future. “We suspect more eviable open source vendors will emerge in the next few years (maybe Cloudera or Hortonworks?) as open source becomes more widely accepted by commercial customers.”
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