My boss, Thomas Lah, is clearly on a roll. Many of the services economy principles that he has been talking about for some time and that are articulated in his new book, Bridging the Services Chasm, are playing out — as if on cue — in the tech industry news. Just in the last couple of weeks, he’s blogged about two noteworthy examples of this here, and here. In a nutshell, we’re witnessing a proverbial sea-change in the technology sector, particularly among technology product companies. Organically in some cases, and through huge acquisitions in others, technology providers are simply becoming more services centric. We’ve been documenting this general trend for some time, leveraging among other things, the huge amount of data we have from our quarterly TPSA Service 50 program. Analyzed together, software and hardware companies now have more revenue coming from services than from products. For the software companies in the TPSA Service 50, our latest data (Q209) show that almost 70% of revenues is coming from services. And we’ve only begun to understand the implications of developments such as these.
What Thomas is saying about these trends in general and about such noteworthy examples of turbulence (Dell/Perot, Xerox/ACS) is the impetus for this blog. Among many takeaways in Thomas’ latest entry, these two are especially important:
- The high tech industry is truly maturing [meaning ... changing], and
- High tech companies, analysts and business press are woefully unprepared for this reality
The combination of these things is what’s got Thomas a bit queasy. I share that queasiness. It’s true that analysts and the press are missing and misunderstanding the changes that we’re seeing in the tech industry. But if the tech industry itself is failing to understand and adequately confront the services chasm that is right in front of them, how can we expect industry followers to do it? This begs a simple question: how ARE technology companies confronting, as Thomas puts it, “the harder issues that will face all product companies experiencing a significant shift in their business model?”
Well, one way to tackle this is to try to isolate and analyze upward dynamic pressure on the services businesses of technology product companies (hardware and software companies). Using Service 50 data from Q208 and Q209, I’ve created measures of change in both absolute services revenue and percent of services revenue relative to overall mix. This amounts to two categories of companies:
- Companies that have seen their services revenues grow over the last year; and
- Companies that have seen the services revenue contribution increase over the last year
First let’s look at the basic frequencies:
The first observation is that the two patterns (absolute and relative services growth) are very different. By far the largest group of companies experienced absolute declines in services revenue. In stark contrast, only 7% of companies saw the relative share of services in their overall revenue mixes decline between Q208 and Q209. So we have two different but related kinds of disruption in the system. On the one hand, we see a generally shrinking revenue pie, as we’ve documented many times before. At the same time, the revenue mix within this shrinking pie is changing rather dramatically and very strongly in favor of more services revenue in the mix. This is a double whammy of dynamism in the system. It’s no wonder Thomas is feeling so queasy and the analysts and the press are at such a loss.
The question then becomes … how are companies dealing with these pressures? If companies experiencing the change are showing signs of handling things with aplomb, then perhaps we don’t need to feel so queasy about what might lie ahead for the tech industry? Well, we certainly don’t have all of the answers, even with our excellent Service 50 data set. But we certainly do have some indications. Let’s look first at companies that are seeing absolute growth in services revenue? How do their key financial performance metrics compare, Q208 - Q209?
The table above shows average financial results for companies that saw absolute growth in services revenue as compared to companies in which services either remained flat or shrank. While both groups of companies saw declining product margins (which happened virtually without exception across the industry), the “services growth” group saw both their services margins and net incomes decline. In contrast, the group with flat or declining services revenue experienced the opposite: increasing services margins and net income levels. Let’s look at the same comparisons, but focus instead in relative mix changes.
And here we see a similary (but actually worse) story. Companies that experienced a shift in the direction of services in the revenue mix saw worse trends than the group that saw either no change or a change away from services in the mix. Specifically, companies that shifted towards a more services intensive revenue mix had larger declines in product margin, and showed a flat trend on services margins and net incomes, while the other group actually saw substantially increased average services margins and net incomes.
As I’ve admitted, this isn’t a complete test of how technology companies are handling the fundamental business model changes that are confronting them. But the signs we do have from this test are not good ones. Companies that experienced absolute gains in services revenue did a little worse, year over year, in driving margin out of that services revenue and a little worse in terms of net income. Companies in which there was a shift in revenue mix toward a more services intensive revenue mix saw no improvement in services margins. In either scenario, the news is bad. Ask yourself … how long can companies see more of their revenue coming from services, while either doing no better or worse in terms of services margin, all the while holding the line on bottom line performance? Right … not much longer. In short, get out the Pepto-Bismol, but have a “queasiness bag” handy as a back-up.
