The Good (Software) Times Have Rolled

Pricing pressures and fewer selling opportunities mean the days of high growth and high profit are gone forever.

Time passes fast when you’re having fun, and, by and large, the past 34 years have been fun for those of us in the software industry. Can you believe that this past June was the 34th birthday of the computer software industry? On June 6, 1969 IBM announced it was “unbundling”—the company would henceforth price software separately from hardware. With that announcement, IBM legitimized the nascent software companies and launched one of the world’s most important and innovative industries.

It’s an industry that has gone very far, very fast. I can recall the first computer I programmed—the UNIVAC II. It took up a large room, yet had far less power and user friendliness than this ThinkPad I am using to write this. UNIX boxes and PCs now populate the corporate data center along with massive mainframes. The priests of the computer room are being replaced by the computing utility. Grandparents use the Internet daily. IBM is backing Linux, a free operating system.

A lot of money has been made in the software business over the past 34 years. Very high profit margins were not uncommon in the ‘80s and early ‘90s. Small software companies grew to become international money machines employing hundreds. But, as we know, the software business has not been doing well of late. Finding software companies earning real profits in 2003 is a challenge. Some attribute this poor financial performance to the business cycle. When the economy picks up, their argument goes, the software industry will return to its days of high growth and high profits. I disagree. Here’s why.

Time: Although it may be hard to see when you look at a specific company, the software industry has matured. It is, after all, a third of a century old. Most of its pioneers are retired or dead. I’m reminded of the industries of the early twentieth century – railroads, telephone, electric utilities – which had glory days similar to those of the software industry. Of course, these industries are still around, but the period of high profits and high growth are long past. These industries changed the way we live as much as the software industry has, yet they faded. Why should the software industry be any different?

Consolidation: More than the simple passage of time has stopped software’s glory days. First, there is the general economic trend toward consolidation. This brings two strikes against the software industry: fewer selling opportunities and a conservatism that burdens smaller companies. Take, for example, Verizon—the result of mergers of New England Telephone, New York Telephone, Bell Atlantic, and GTE, each of whom probably bought similar software, perhaps from different companies.

Now that Verizon has consolidated these four formerly independent companies, it is eliminating duplicate products, thus reducing selling opportunities. It is also squeezing prices as it eliminates duplication by giving its business to the company offering the best deal. It’s no secret that management of Fortune 500 companies is fundamentally conservative. As companies grow larger through mergers and acquisitions, they tend to become even more conservative. What CIO would recommend the product of a small software company to his boss, who has never heard of the small company? Would the CIO jeopardize his six-figure salary?

The buying practices of Verizon’s CIO were highlighted in a recent Wall Street Journal article. The CIO's mission is to cut costs, the newspaper reported; last year he cut $100 million, this year he wants to cut more. He attributes part of these savings to computers and associated technology becoming commodities (and being priced accordingly). Commodity pricing is not what brought the glory days to the software industry. Far from it! The Journal article also brought home the changing role of the CIO, who is now looked to primarily for business acumen. A CIO is measured on business results: increased profits and lower costs. Thus, in many cases the CIO will not look at products that don’t show immediate financial results or may come with higher-than-desired risk.

Standards: The past decade has seen a move to standards, which, from a macro-economic level, is a good thing. However, standards enable companies to switch their applications from one machine to another more easily – and at less cost—than moving from IBM’s MVS to an operating system of one of its competitors. The move to standards has had a particularly negative impact on the mainframe software business, the most obvious being that there are fewer mainframes needing software. Standard machines are cheaper, which tends to drive down the price of software as well. Hence, the software company is faced again with fewer selling opportunities and lower prices.

Globalization: There's no question that globalization is on the horizon. We've seen it in application outsourcing and, to a degree, with some software product development. But the surface has only been scratched. The cost differential in producing software here or in India (or another developing country) is large. It remains to be seen whether our marketing prowess can offset that cost differential.

I’m not arguing that the software industry is dying. It has simply matured. It will be inordinately more difficult for a newcomer to make its mark. Pricing pressures and fewer selling opportunities (through consolidations, more business-oriented CIOs, standards, globalization) mean that the days of high growth and high profit are gone, never to return. It was fun while it lasted.

About the Author

Al DeVito has held senior management roles in several software companies. Currently semi-retired, he is a principal in SMB Management Solutions LLC.