Dave Michels
Dave Michels is a Principal Analyst at TalkingPointz. His unique perspective on unified communications comes from a career involving telecommunications...
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Dave Michels | June 26, 2014 |


Business Models Disrupted by the Cloud

Business Models Disrupted by the Cloud Cloud services are not just an entirely different business model, but the next business model. The technology and the economics are disruptive, requiring end users and analysts to set new expectations.

Cloud services are not just an entirely different business model, but the next business model. The technology and the economics are disruptive, requiring end users and analysts to set new expectations.

For the second year in a row the country's highest paid CEO came up short when Oracle announced year-end results. Last week the company missed analyst expectations on the top and bottom lines. A year ago, it missed expectations on revenue.

Investors are wondering if Oracle is in trouble. Last year the company blamed the shortfall on inexperienced sales executives. This year CEO Larry Ellison blamed it on its growing cloud focus, and he says it's a good thing.

The story of Oracle provides another example of how cloud economics are a mixed and confusing bag. With just a little bit of irony, an "Oracle" provides us wise and authoritative lessons.

Ellison explained that Oracle's revenue will suffer as the business shifts toward the cloud. This raises the obvious question of why companies would pursue such a fate. Ellison said it's "OK, because in the long term we make much, much more money [with cloud services]." While the future performance of Oracle is uncertain, the cloud conversation is something the UC industry has been living. Cloud is more than a delivery mechanism; it's a whole a new business model.

The central issue is how and when revenue gets recognized. With traditional software sales, vendors recognize the revenue with the initial sale. Big celebrations (and commissions) coincide with the capital sale. Also around this time, the vendor pays most of the sales expenses. This model is well understood, and it didn't change as the industry transitioned from hardware to software.

With cloud services, revenue gets recognized as it is delivered--usually monthly. To clarify, a three year service contract realizes 1/36th of the contract value as revenue every month, which delays booked revenue and profits. Since many of the costs are still on the front end, the break-even point gets pushed out, often more than a year. As a result, revenue and earnings become less reliable indicators of a business's financial health.

Because revenue becomes recurring, new sales of any kind equate to revenue growth, though profits are deferred and often elusive. Funding growth can be difficult for any firm, but especially for cloud providers as they build out their solutions today, to accommodate deferred revenue.

Companies transitioning from software (or hardware) to cloud services have it tougher than pure cloud plays because they are held to traditional standards. The shortfall at Oracle is causing angst for shareholders, as we have seen with UC vendors transitioning their businesses. Pure cloud providers, without the baggage of traditional models, often get a pass on profits., for example, has posted a GAAP profit in only a few quarters of its existence, yet its revenue and stock perform well.

So why is the cloud business so attractive?
Providers are confident that growth in subscriptions will eventually deliver long-term riches primarily for two reasons. The theory goes that since most of the expenses are upfront, longer-term customers will generate steady profits. Secondly, the market is still young, and vendors see a land grab opportunity. They hope to leverage their commitments into early-mover advantages.

These two factors are causing providers to forego profits and plow whatever they can back into the business. That long wait for profits makes customer retention critical. No one likes to lose a customer, but it's less painful for traditional vendors as they realize their profit early in the relationship. Growing the cloud with net-new customers has magical effects on the business, but it's harder than it sounds. Customer loyalty is more fragile without the crutch of a capital investment.

Cloud providers need to drive retention and consumption. That's why marketing costs are so high for cloud providers. Multi-year contracts are not sufficient; marketing efforts need to attract new customers and expand existing accounts. Top providers utilize various tactics to drive consumption. This is why spends more than 50% of its revenue on marketing. Though many providers don't do this - instead they offer hosted implementations of products.

The truly successful providers are building moats to keep others away from their customers. Consider this page from the Netflix playbook. Netflix provides on-demand video content for a flat fee. By driving consumption, Netflix increases its value to subscribers (thereby reducing cancellations). Netflix works as hard or harder to drive consumption as it does to sign up new customers. The company offered a million dollar prize for an improved content recommendation algorithm. Consumption is also why the company monitors and champions ISP performance (customer experience). Additionally, as Netflix transitioned to cloud, it focused more on television content because a series invites repeat viewers.

Customer turnover, or churn, can starve a provider from realizing profits. Though churn rates alone can be misleading, they need to be compared to growth rates for context. Growth and churn are levers that affect net growth, just as revenue and costs are the levers of profit.

Another way to retain customers is integration into business processes. The broader and more integral the solution, the more sticky it becomes. The three most popular ways to entangle services into processes are rich APIs, tightly integrated vertical solutions, and complementary services.

The biggest part of the cloud transition is really embracing the new model, and moving away from the initial sale mindset. In UC we are seeing several providers fortify their solutions with cloud-first approaches. Here are just a few examples:

• 8x8 has been highly acquisitive, broadening its reach and IP
• Interactive Intelligence's Pure Cloud solution leverages Amazon's hosted infrastructure (Amazon has reduced prices 42 times between 2008 and 2014)
• ShoreTel aims at end-user satisfaction, including its focus on direct support and NetPromoter scores
• MetaSwitch is on the forefront of NFV architecture

Cloud services are not just an entirely different business model, but the next business model. The technology and the economics are disruptive. End users and analysts need to set new expectations.

Oracle reported $37.18 billion revenues for the year. Analysts were looking for $38.45 billion, or an additional $1.27 billion. Within Oracle's figures were $450 million in Q4 cloud revenues. "Our cloud subscription business is now approaching a run rate of $2 billion a year," said Oracle President and CFO Safra Catz.

The unanswered question is how much that $2 billion represents in lost product sales? Probably $4-$6 billion, which would have exceeded analyst expectations on Oracle's revenue and profit.

Dave Michels is a Contributing Editor and Analyst at TalkingPointz.

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