SAAS Providers - Is it a Software or Service Provider Investment?

Software-as-a-Service (SAAS), formerly the Application Service Provider (ASP) is back in vogue. But this time with good reason. Many of the operational kinks have been worked out, thanks to businesses like OpsWare (OPSW) and Jamcracker.

Investors are very interested in this new working business model. So subsequently there are many businesses touting themselves as SAAS businesses.

Now a company can call itself whatever it wants in its press releases and acronyms come and go. So when I want to know if a duck is really a duck, I look at the Gross Margin. Gross Margin is the number you get to after you subtract the Cost of Sales from Sales. Cost of sales is the cost to produce real units of a product, not the cost to sell it or develop it or administer it, but to "make" it.

So what is the natural Gross Margin for a SAAS provider? How can I tell if I am really talking to one?

Traditional software providers typically have big gross margins. If it helps, think about it as low cost of sales. Replicating and distributing software, even if you still use a shrink box, is not expensive.

Here are the Gross Margins for some big software companies: Microsoft (MSFT) - 83%; Oracle (ORCL) - 77.5%; SAP (SAP) - 66%. In the software business most expenses are in R&D and Sales & Marketing.

On the other hand, Network driven service providers typically have lower gross margins. They need to buy routers and fiber and datacenters. In short they need facilities, often including software licenses, to deliver the service. They usually do not spend as much on R&D or software development.

Here are the Gross Margins for some big Network Service Providers. I picked NSPs that are primarily IP networks, because we believe in an IP centric world. PSTNs, Cellular carriers and other NSPs would have similar Gross Margins. Level3 (LVLT) has a Gross Margin of 38%; Savvis (SVVS) - 35%; Global Crossing - 25-15% over the last two years.

So what is the right Gross Margin for a SAAS provider? If they need the facilities to distribute the software AND the R&D to develop the software, what's left for the shareholder?

We believe there will be SAAS providers of two types. Some will gravitate toward developing proprietary software and outsource the IP infrastructure needed to deliver and manage it. Others will focus on delivery and management while outsourcing by licensing with the leading software providers. For example Microsoft turns Outlook into a SAAS product called Exchange and its daily delivery and management is provided by groupSPARK. The incremental margin of moving one more application over an already built network is close to zero. Why build a network for one application?

We anticipate Gross Margins for the two types of SAAS providers, software-focused and delivery/management focused, will mirror the margins achievable pre-SAAS phenomena.

Curious about what approach your SAAS provider is implementing? Check the Gross Margin! SAAS notwithstanding they are still a software developer or a network provider.

In the next article, I will talk about why Akamai Technologies (AKAM) with an 80% Gross Margin and its own network rebukes everything I said above. But more importantly we will talk about why I still think I am right.