Wednesday, November 21, 2007

Business Mix - Microsoft

In order to classify the larger software companies into the industry categories, it will help to quantify the mix of businesses that each participates in. Whereas the smaller companies will more likely be considered "pure plays" (falling into just one category), many of the larger ones will fall into more than one category.

As a rather obvious example, Microsoft has products and services that could be classified as Enterprise Applications (e.g., Microsoft Dynamics), as Infrastructure Software (e.g., Windows Server, SQL Server), and as Games (Xbox 360 and PC software). Microsoft also introduces another major software category, Desktop Applications, in which they are effectively the sole participant with their Office suite. And Microsoft has several non-software businesses (e.g., Xbox consoles, advertising, MSN) -- although it is far from clear that these non-software businesses make any positive contribution to Microsoft's market cap!

Pages 23-28 of Microsoft's FY 2007 10-K provide much of the data needed to infer Microsoft's revenues and earnings at a fairly detailed level. I won't show all the analysis here, but I should note that I did make four assumptions: (1) that Xbox consoles wholesaled at $350 each during FY07; (2) that the Server and Tools business split 45%-45%-10% SQL Server-Windows Server-Other; (3) that Microsoft Office comprised 92% of the Business Division's revenues; (4) that each division's operating margin could be applied uniformly to all the businesses within that division.

It's interesting to note that Microsoft's "core businesses" -- Windows and Office -- are two businesses in which it makes virtually all its profit, and (unsurprisingly) the two businesses in which it has nearly dominant market share. Both of these businesses face limited growth and potential eroding share, which is no doubt part of the reason that Microsoft has attempted to diversify beyond this core.

But other than the relational database business, where Microsoft appears to earn a decent profit and where it has a respectable market share, none of the other businesses appear to be making any significant contribution to Microsoft's profitability. Microsoft has a disadvantaged position against Google in the advertising business, and falls well behind Oracle and SAP in the enterprise applications arena.

Already this picture raises some questions about Microsoft's business portfolio. Is Microsoft taking the best steps possible to defend its core business and maximize its profit potential? Does Microsoft ever have a chance of achieving significant profitability in its non-core businesses, and what have to be true in order to believe that they could? Are there more sensible business adjacencies that Microsoft should pursue instead of these businesses?

Monday, November 19, 2007

Adjusting the Categories

A few additional thoughts on how the categories are organized:
  • It may make sense to analyze the enterprise software vendors based on the business processes they cover. These processes could include product design, inbound logistics, manufacturing, outbound logistics, sales and marketing, procurement, HR, planning, finance and accounting. Smaller enterprise software vendors might offer a product line that covers only one or a few processes, whereas the large vendors (SAP and Oracle) would offer a far more complete suite.

  • If we do analyze the enterprise software vendors based on business processes, then it might make sense to classify the engineering and design software companies within this framework, perhaps as Product Lifecycle Management applications supporting the product design process.

  • The two largest "Other" companies in the previous post are VMware and Adobe. VMware would almost certainly belong in the Infrastructure Software category. Adobe is a bit harder to classify; perhaps it will make more sense to think of Adobe as a portfolio of businesses that spans several categories.

Market Cap of Each Category

The following chart compares the market capitalizations of the companies in each category. (I've renamed several of the categories but for now have kept the same classifications).

Microsoft aside, the enterprise software vendors (led by Oracle and SAP) form the largest category. The second largest category consists of the "infrastructure software" companies. Video games, the only consumer segment that appears here, form the third largest category. The engineering and design category is even smaller.

Also interesting to note, aside from video games and some portion of Microsoft's product line, there is almost nothing here that would count as a consumer software segment. Most of the big companies who write software that consumers use (Google and Apple and AOL, for example) essentially give the software away for free and make their money elsewhere (advertising, content, services).

Sunday, November 18, 2007

Preliminary Classification of the Top 50 Software Companies

Business Definition, Customer Sharing, Competitor Sharing

This post outlines a preliminary classification of the 50 largest software companies. This time I'm using Google Finance's Software & Programming category as the data source. I'm again using market capitalization as the measure of size. I've excluded six companies (VMW, GA, SAI, STV, OMTR, SLH) which do not have any Related Companies listed by Google.

The Related Companies lists on Google Finance help to describe a sort of clustering of the companies. In the chart below, a solid line between two companies indicates that each is on the other's Related Companies list. There are also a few Top 50 companies which did not appear on the lists of any other companies; in these cases if there was a one-directional relationship then that relationship is indicated on this chart with a dotted line.

I have tentatively identified four clusters that seem to emerge out of these relationships. Each cluster is highlighted in a different color in the chart, and can be identified with a different type of customer group.

The first group consists of companies who sell primarily to video gamers. These are indicated in light purple.

The second group consists of companies who sell primarily to general business managers. These are dominated by the ERP, CRM, and Business Intelligence vendors. These are indicated in green

The third group consists of companies who sell primarily to engineering and design professionals. These are indicated in yellow

The fourth group consists of companies who sell primarily to IT and E-Commerce professionals. These are indicated in blue. This is a rather diverse group, including such companies as security software makers, middleware vendors, and Indian IT development shops, and will almost certainly need to be subdivided further

The categorization is not comprehensive. Several companies did not clearly fall into any of these categories; these companies are indicated in white on the chart. Additionally, MSFT seems to participate in at least three of the four categories

My next steps will be (1) to compare the sizes of these categories and (2) to select one of the categories for more detailed industry analysis. After analyzing the first industry, I expect to revisit the overall classification scheme

Thursday, November 15, 2007

Organizing the Project

To help organize the work, I have drafted a high-level framework that shows the steps I expect to take while analyzing each part of the overall software industry:

These steps may be repeated for each industry, company, and investment hypothesis under consideration.

After repeating these steps enough times, some patterns may emerge that could then help test and/or revise the original hypothesis.

Wednesday, November 14, 2007

Identifying the Major Software Companies

Who are the largest publicly traded software companies?

I searched the Technology section of Yahoo! Finance and selected the twenty largest companies, by market capitalization, across four categories: Application Software, Multimedia & Graphics Software, Security Software & Services, and Technical & System Software.

The results are as follows:

(The actual market caps for MSFT, ORCL and SAP are $312, $100, and $60 billion respectively. This is my first try at using Google Docs for charting, and it is not yet clear to me how to create the visual cues on the chart itself to indicate that these three companies have values that exceed $40 billion.)

This approach does miss a few companies that I would probably consider in scope for this blog. These companies are buried in other categories. For example, Symantec is classified in the Internet Software & Services category, which mostly contains companies whose primary source of revenue is from services rather than software sales. As another example, NAVTEQ appears in the Business Software & Services category, which is dominated by companies such as ADP whose primary source of revenue is from services rather than software sales.

Tuesday, November 13, 2007

Launching the Software Strategy Blog

This blog will explore the following hypothesis:
As the software industry matures, software companies will have to employ more "old economy" strategies and fewer "new economy" strategies in order to compete successfully.
Let me explain how I am using several of these terms today. Please bear in mind that one of this blog's goals will be to clarify these definitions!

  • Software industry: At least initially, I would like to concentrate on companies whose primary business is developing and selling software. This would include such names as Adobe, Autodesk, Intuit, Microsoft, Oracle, SAP and Symantec. This definition excludes a number of well-known companies which are renowned for their software development capabilities, but who make their money elsewhere. For example, this definition excludes Google (most of whose revenue is from advertising), D. E. Shaw (most of whose profits are from trading using proprietary software), EDS (most of whose revenues are from services), or indeed most of the "Web 2.0" companies. It remains to be seen whether this is a meaningful distinction.

  • "Old economy" strategies: Here, I refer to the business strategies that companies in the manufacturing and service sectors have used to compete successfully over the past four decades. These would include such concepts and disciplines as economies of scale, barriers to entry, process re-engineering, six-sigma quality, etc. These strategies are the bread-and-butter of most traditional strategy consulting firms and most business school curriculums. You tend to read about these sorts of strategies in the Harvard Business Review.

  • "New economy" strategies: Here, I refer to the business strategies that have helped many of the relative newcomers in the technology industry succeed. These strategies would include such concepts as first-to-market, innovation, knowledge management, multifunctional teams, etc. You tend (tended) to read about these sorts of strategies in Business 2.0 and Red Herring long before the "old economy" press heard about them.

  • Compete successfully: A slightly briefer way to say "create and retain sustainable competitive advantage" (using the language of Michael Porter's Competitive Strategy canon) or a slightly more verbose way to say "win" (using the language of the Boston Consulting Group's book Hardball).

Of course, for a long time software companies have successfully employed "old economy" strategies (Microsoft comes to mind), and "new economy" concepts such as product innovation will always be an important aspect of any successful software company's strategy. But I suspect that the relative importance of these two kinds of strategies will continue to shift.

I hope to learn and share some useful insights while writing this blog. Who knows where this may lead, but perhaps there will be something useful learned which may have applications for strategic planning and/or investment decisions.

I expect to draw upon a range of sources in addition to conducting some original analysis; these sources could include published studies and articles on the industry, news coverage of current events in the industry, books and publications which more broadly consider competitive strategy topics, SEC filings, and equity analyst reports.

Monday, November 12, 2007