SI Revenue at Risk

Or, The Value Of Pro-active Cannibalization

Recently, I have begun to work with SI’s in their transition to the Cloud. While the perception of what Cloud-based demand will mean to their business varies (some think it will impact them significantly, others not), what most will acknowledge is that it is NOT a fad. The demand for Cloud-based solutions is real, and everyone will have to adapt to that market reality. It’s a question of how, and how fast.

And here’s the rub – demand for Cloud based solutions will come at the expense of traditional services revenue streams. Let’s not forget the real reason for Cloud demand – it has nothing really to do with the technology itself, it has to do with customers (from the small business all the way up to the global enterprise) wanting to reduce their overall IT costs, and shift the way they consume IT from a capital expenditure to an operating expense. So some level of traditional SI services revenue erosion is inevitable.

And we should make no mistake, the impact of even relatively small revenue shifts for SI’s will have major implications on the value of those businesses. Consider the following example.

An SI Today With $20m In Annual Revenue Will Have, At Best, The Following Profile:

Now let’s consider what would happen if 5% of current revenue were to be lost. First of all, it would be virtually impossible to rationalize costs to a level sufficient to restore profitability. Staff would be kept in place, sales and marketing expenditures would remain more or less constant, and G&A would not shift materially. So here’s what that same SI would look like after a 5% revenue erosion:

The bottom line is, a 5% revenue erosion could erase as much as 20% of the company’s value. A 10% erosion would wipe out over half the owner’s equity. Clearly, this is a situation every owner would want to avoid.

And here’s the stark market reality – Cloud demand will be met, it’s only a question of by whom, you or your competitor. If you’re not proactively promoting Cloud offerings, you can bet your competitor is. If you don’t get to your customers first, you will lose them.

In short, the only real way to prevent long-term revenue erosion is to pro-actively cannibalize your own short-term traditional revenue streams. And of course, replace them.

The Question Is, What With?

In the short term, there are really 3 possibilities.

The First:

• Is a Cloud transition offering, designed to deliver to customers a roadmap to take advantage of the Cloud, and lower their overall cost of IT. Obviously, this will take away from potential future (traditional) revenue streams, but better you do that to yourself than a competitor.

The Second:

• Is to rekindle projects that did not earlier proceed because the infrastructure cost was too high for the customer to justify. Infrastructure and platform costs will be greatly reduced in the Cloud, making some of these projects now an attractive investment to the customer. This is a source of replacement services revenue, in the short term.

The Third:

• Is to integrate legacy systems, which will not soon be replaced, with Cloud-based applications. This extends the lifespan for these systems, allowing the customer to capitalize on the savings afforded by the new breed of Cloud-based systems which will surely emerge to replace legacy systems, over time.

This addresses the first part of Cloud demand – the customer’s desire to lower IT costs. In the long term, however, we need to remember the second fundamental aspect of Cloud demand – to shift the way IT is consumed, from a capital expenditure to an operating expense.

To meet this aspect of demand, of course, new offerings that can be consumed on a subscription basis will need to be developed. This will have obvious implications in terms of short term cash flow, to say nothing of the development costs associated with bringing these offerings to market.

The SI who successfully transitions to the Cloud will therefore engage in an “orderly unwinding” of their traditional revenue streams (a.k.a. pro-active cannibalization), while shoring up that revenue erosion in the short term with Cloud “transition” offerings, and simultaneously investing in the development of “productized” offerings that can be sold on a subscription basis.

Quite the balancing act, to be sure.

But then, the price for inaction will surely be even steeper.

Unless, of course, this whole Cloud thing is just a fad.