What Is Happening?  While the Software-as-a-Service (SaaS) sector will continue to experience explosive top-line growth over the next few years, a tough economic climate will clearly help define who the ultimate winners will be. Smaller SaaS vendors will be particularly vulnerable, with a scenario of segment consolidation lead by hungry ISVs and mid-to-large size SaaS pure-plays vying for category leadership.

Why Is It Happening?  In spite of the recent upward revision in US GDP growth for Q208--3.3 percent rather than the early "advanced estimate" of 1.9 percent--most senior business and IT executives (and economists) aren't convinced that the US economy has turned the corner and is on the road to a more sustainable growth scenario.

No doubt the US government-issued rebate checks helped stimulate short-term consumer spending. However, Q208 appears to look more like a "head-fake" rather than an indicator of a resurgent economy. The dual headwinds related to the unwinding of the credit and housing crisis in the US, combined with a slowing of consumer spending (and a decline in payroll growth) suggests continued economic malaise. Many economists are forecasting at best a 1 percent US GDP growth for Q308, with full-year US GDP growth estimates in the 1.7-1.9 percent range for both 2008 and 2009--well below the 3.0+ percent target growth rate most believe the US economy can sustain.

Internationally, much of the Euro Zone and the UK are already in or approaching recession. In contrast, key-developing economies such as China, India and Brazil are poised to merely experience a "growth pause," rather than true economic contraction. The good news is that the decline in commodity prices (including oil) and the strengthening of the US dollar should put the worldwide economy on a better footing for sustainable growth longer-term--although the global financial crisis will likely continue to play out for another 18-24 months.

Market Impact: Yet despite a tougher economic climate, it does not appear that central IT budgets will get cut dramatically in 2008 and 2009, as they did during the previous IT spending downturn that occurred earlier this decade. Part of this is due to the fact that centralized IT budgets did not balloon in size and return to their pre-2001 levels once IT spending growth resumed in the 2004-2005 timeframe. As such, most IT budgets aren't as fat today to begin with.

In fact, a recent Gartner revision to its 2008 and 2009 IT spending forecast supports this scenario, suggesting that overall worldwide IT spending (including telecom) will grow 8 percent in 2008, despite the tough economic climate that we are experiencing. In Gartner's view, worldwide software spending will continue to grow 10 percent in 2008, and 8 percent in 2009, followed by strong IT services spending growth of 10 percent and 7 percent respectively. Clearly, the emerging BRIC economies are driving a significant portion of this growth.

However, what is occurring is a reshuffling and realignment of the spending mix toward on demand solutions such as SaaS and Cloud Computing, the most significant architectural shift that has occurred in enterprise computing since the mid-90's. Like client/server, the undeniable trend toward on-demand solutions, combined with the impact of open source, greater enterprise mobility and other emerging and disruptive technologies, is bringing about a dramatic rethinking of how and where business systems are being deployed, and value created.

What Does This All Mean For Enterprise Software and SaaS? In tougher economic times, the easiest thing for IT and business users to do is to sit tight and do nothing--delaying purchase decisions until such time as broader company goals line up with short-term spending realities. In the past, this behavior has especially impacted traditional enterprise infrastructure and packaged business application (on-premise license) providers. But it appears that SaaS companies are now potentially vulnerable to this trend as well. Find below two key trends that will help define the SaaS landscape in the next 2-3 years:

1. Small / Emerging SaaS Providers Bear the Brunt. Those most vulnerable in this economic scenario are the small up-and-coming SaaS providers that have yet to establish a significant enough customer base that will allow them to ride out the storm. Given the "build it, they will come" nature of SaaS, with a predominately pay-as-you-go subscription framework, a large number of recently funded SaaS start-ups no doubt will struggle. For example, we applaud Bungee Labs for recently pruning their aggressive growth plans and trimming some staff to help preserve cash during what may be a period of slower sector growth.

Further, many Wave-I "niche" SaaS investments and deployments are funded by business unit and departmental budgets--rather than via centralized IT--where many project-based initiatives of this kind are viewed as discretionary investments.

At the same time, however, SaaS providers focusing on core systems of record for mid-to-large enterprises will likely find that they too will see decisions increasingly being delayed, in spite of a potentially strong ROI story (e.g., Workday).

But regardless of whether SaaS is funded centrally or by a business unit, a slower economy clearly will mean not only fewer and smaller initial transactions, but also slower growth from installed customers as new seats are added at a reduced rate. The net of this is that while SaaS and on demand infrastructure is on an incredibly strong growth trajectory, it too will face the brunt of a slower global economy.

2. Consolidation Will Rule the Day--Category Leaders Emerge. With longer time-horizons to exit their SaaS investments, increasingly anxious venture investors will likely separate out the visible winners from those treading water, identifying potential buyers for assets that haven't yet gotten significant traction and that might require significant new rounds of investment. Even in the relatively healthy 2004-2007 period, it became clear that SaaS investment horizons are typically 2-3 (+) years longer than with traditional on-premise software firms. Saugatuck believes that this will clearly benefit hungry ISVs looking to enter the SaaS fray, as valuations fall.

At the same time, Saugatuck believes that 2009-2011 will be a period when a number of pure-play SaaS companies vie to become category leaders via acquisition of complimentary functionality-- and this will likely occur not only in traditional business solution segments such as CRM, Financial Accounting, HR and the like, but important emerging sectors as well such as Governance, Risk and Compliance (GRC).

A key issue is whether the new suites that will emerge will be primarily role-based or cross-functionally based. A good example of this trend can be found with the recent acquisitions by Tale. Given buyer behavior toward best-of-breed solutions thus far, over the short-haul a focus around role- and function-based suites (i.e., Finance, Sales, Human Resources) are likely to dominate over cross-functional suites--except for the smallest of companies where a consolidated dashboard of functionality can make sense. Over time, as the SaaS market continues to mature and appeals to ever-larger enterprises, cross-functional business suites (e.g., ERP, CRM, Financials) no doubt will find their place in the sun.

The Bottom Line: The good news is that established SaaS companies have deferred -revenue-based business models that provide great revenue visibility--and which therefore allows them to better plan and match expenses to projected cash flows (vs. traditional enterprise software companies). So even in a tough economic climate, those firms that have already emerged will likely only grow stronger, as they can both better manage the downturn while potentially leveraging attractive acquisition candidates to their advantage.
For users, it is important to continually monitor the deferred revenues of public companies that they are evaluating--as even some of the SaaS giants like Salesforce are starting to show a flattening out of deferred revenue over the past two quarters, even though the top-line continues to grow nicely.

Interestingly, unlike the spending environment in the post-2001 bubble, many mid-to-large size enterprises have significant cash on their balance sheets. As such, this may play to the advantage of all enterprise software companies--both traditional on-premise license players as well as SaaS providers--as users continue to replace older assets, and the focus of IT spending shifts to a new cloud-based architecture. What we haven't yet seen in this economic cycle is a significant upturn in spending to save money, as we did the last time around. If the market shifts in this direction, this could be a clear accelerator for SaaS even in tough economic times.
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