Enterprise Software Firms Rush to Plant a Stake in the Cloud

Grazed from The Motley Fool. Author: Daniel Ferry.

Enterprise software is typically a staid field. Customers in this industry tend to be sticky: businesses often stay with their incumbent provider due to the high switching costs of retraining staff and IT departments for a new system. This has been especially true while business software required physical installation on local machines.

However, as storage and processing increasingly takes to the cloud, companies are rethinking their software needs. Cloud computing is typically more efficient, as the machines that actually store and compute data in the cloud are far more powerful than local machines. It’s probably inevitable that most, if not all, enterprise customers will eventually migrate to the cloud. This creates a rare juncture for customers to choose new enterprise software en masse. In an industry with high customer retention rates, capturing a big market share today pays off well into the future. The rush for cloud computing customers therefore resembles an Old West-style race for prospectors to stake their claim in gold country…

New entrants focused solely on cloud computing are working to grow their market share before older, established players are able to transition their large installed customer bases over to their own cloud services. Salesforce.com (NYSE: CRM), the largest cloud-only provider, understands this very well. CEO Marc Benioff has poured resources into marketing and sales, at the expense of profitability, in order to capture as many customers as possible before enterprise giants can get competing offerings up and running. However, while growth for Salesforce has been high, expectations may be even higher. To merit its current valuation on a discounted cash flow basis, Salesforce would need to grow top-line revenue by around 20% annually for several years, and slowly rein in its costs growth to under 10% by the end of the decade.

Smaller cloud-centric peers like NetSuite (NYSE: N), which in recent years has seen lower revenue growth and much higher marketing and sales expenses than Salesforce, would have to work even harder to grow market share while expanding margins.

But if these seem like huge challenges for the upstarts, the safe money is not necessarily with the enterprise establishment. After just launching its cloud computing platform last month, enterprise giant Oracle (NASDAQ: ORCL) faces the daunting task of completely transforming its business model. Built on software and database installation and licensing, in taking on the cloud Oracle must transition to a subscription model and a new portfolio of products. A slip-up like a breach in security or interruption of access to its cloud services could cost Oracle dearly, losing it the trust of the large clients it relies on. Despite being a trusted name in enterprise solutions, Oracle is not yet a trusted name in cloud computing, and the company must navigate a minefield of opportunities to alienate clients.

With the cloud offering new, cheap, and often customized applications for business computing, enterprise clients may find they no longer rely so heavily on the Office suite, or indeed even the Windows operating system, the two great cash cows of Microsoft (NASDAQ: MSFT). At the very least, as Microsoft introduces its Office suite as a subscription service hosted on the cloud, it should expect to command less pricing power and lower margins. Microsoft does have high hopes to capitalize on cloud computing, however: in 2010 Microsoft launched its Azure service as a platform to develop and host cloud applications, and if this service takes off it could more than make up for the erosion of profitability for Windows and Office. It rebooted Azure last month to more directly compete with Amazon (NASDAQ: AMZN), whose Amazon Web Services segment is far and away the market leader in offering infrastructure-as-a-service, providing computing power and resources to developers through the cloud with few restrictions.

This is an important step for Microsoft—not only is renting out infrastructure a valuable potential revenue stream, but Amazon’s provision of vast storage and incredible computing power on-demand threatens any company that relies on these resources as competitive advantages. The ability of even small firms to rent out supercomputing abilities as-needed erodes the barriers to entry in the enterprise space.

The cloud isn’t just disrupting the way software is used and distributed, it’s increasingly disrupting the way software is developed and scaled. In a world where any developer can build on a great idea without up-front investments in computing resources, it becomes harder to keep an edge in product development. Instead, the most powerful moat a company can build up is a big installed customer base, full of firms and IT departments that know and trust their cloud service. As more firms migrate to the cloud, the players who can claim and keep the most territory will have the most enduring advantage. Despite the challenges facing them, I like that Salesforce is focused on planting a stake in as many claims as it can, as quickly as possible. As the cloud computing frontier opens up, just like in the Old West, you’re either quick or you’re dead.