A bruising third quarter convinced German software vendor SAP that it needed to take swift action. After license sales dropped 31%, the fourth straight quarterly decline, SAP (SAP) started selling new kinds of contracts that are easier on customers' wallets. Not long after the end of the period, which closed in September, SAP began pitching "flexible licensing agreements," to 500 customers that spend at least €1.5 million ($2.2 million) annually with SAP, the world's biggest supplier of business applications. The arrangements let customers pay quarterly or monthly fees to use SAP products, instead of buying the software outright and paying for it at the outset. SAP for years has been giving big customers some leeway in how they pay for software, but the recent slump convinced the company that the flexibility needed to be extended more broadly. These subscription licenses are appealing to companies that may not have the budgets to spend hundreds of thousands, or millions, of dollars in one sitting for the rights to own business software in perpetuity. Instead, more customers want to rent the software and spread out payments. "The customers that are choosing this didn't have capital dollars in the first place" to spend as a result of the recession, says SAP President and executive board member Bill McDermott. "We adapted to the trend." Disrupted RecoveryYet the increasing popularity of subscription deals could throttle near-term growth for business software companies as the economy recovers, since they curtail vendors' ability to collect large software licensing fees at the beginning of contracts. Companies including Microsoft (MSFT), Oracle (ORCL), and Adobe Systems (ADBE) are adding more flexible payment arrangements for customers. "It's going to disrupt the entire software industry," says Brent Thill, managing director for software research at UBS (UBS). Growth in new software license sales—a commonly used measure on Wall Street of software vendors' business health—may not accurately reflect demand for products because subscription deals require vendors to book revenue over time. "License growth rates may not be where everyone would like to see them," says Thill. "Companies could disappoint [investors] during the recovery." Companies looking to save money in the near term are willing to sign up for subscription software deals even though they end up being more expensive than traditional licensing arrangements, analysts say. "Cash flow is king," says Yun Kim, an analyst at Broadpoint AmTech (BPSG). "Companies will do anything they need to do to decrease up-front costs, even though it's more expensive in the longer run." Vendors are offering the subscription arrangements in response to customers' desire to reduce the bite application software takes out of their information technology budgets. Pay-as-you-go licenses also give customers the flexibility to pay more as additional users come online with a system, instead of paying in advance for workers who aren't yet set up to use the software. "Customers want to pay for the software they consume," says Rob Enslin, president for North America at SAP. Subscription GrowthThe proliferation of subscription software is also a response to the popularity of business applications delivered over the Internet for a monthly or annual fee, such as Salesforce.com's (CRM) customer management software, and online document and spreadsheet software from Google (GOOG). "The companies that aren't moving that way quickly enough are at risk of losing revenue," says Liz Herbert, an analyst at Forrester Research (FORR). So far, subscription software licenses are a drop in the bucket for SAP and other large software vendors. Software subscriptions—including companywide licenses at SAP's 80 largest customers including Siemens (SI), Colgate-Palmolive (CL), and Apple (AAPL)—accounted for just 4% of SAP's software revenues in the third quarter, or $116.4 million. Sales of software subscriptions are growing even as traditional software license sales decline. Sales at North American software companies that have reported quarterly results in the past six months declined by 9.6%, according to a Bloomberg analysis. Worldwide revenues from subscription software licenses, including software for IBM mainframe computers, is expected to grow by more than 21% annually to $71.8 billion by 2013, from nearly $34 billion in 2009, according to market researcher IDC. Subscriptions would account for one-fifth of all software sales by then. Other big software companies are proffering subscription deals. Microsoft plans to offer users of its upcoming Office 2010 suite, due next year, the ability to rent an online version of the software on a pay-as-you-go basis. It also sells its Exchange e-mail software and SharePoint collaboration software on a subscription basis. M&A AssistanceAdobe Systems on Sept. 15 paid $1.8 billion for Web traffic analysis software company Omniture, which sells software on annual or longer subscriptions, in order to collect a more predictable revenue stream between releases of its flagship Creative Suite software. Database and business applications giant Oracle may also be poised to sign up more companies for software subscriptions rather than traditional licenses. New applications called Fusion that Oracle plans to introduce in 2010 may offer customers more options for letting Oracle host the software on its computers. If Oracle completes its pending acquisition of Sun Microsystems (JAVA), currently delayed by antitrust concerns in Europe, it could have new options for selling software loaded on Sun hardware on a subscription basis, analysts say. Oracle didn't make an executive available for comment for this article. To be sure, software companies' earnings have held up better than the tech sector as a whole. Net income for North American software companies that reported quarterly results in the past six months grew by 0.7%, compared with a decline of 3.75% at all companies in the information technology sector, according to a Bloomberg analysis. Vendor Bright SpotStill, some analysts see the proliferation of subscription deals as a way for vendors to divert attention from sharply declining sales of traditional licenses. "That's all they've got going on," Brendan Barnicle, an analyst at Pacific Crest Securities, says of SAP's flexible licensing program. During the first nine months of 2009, SAP's software licensing revenue fell 35% to $2.2 billion. By contrast, subscription revenue, including companywide deals at some of SAP's largest customers, increased 21% to $328.6 million. Oracle's new license sales fell 17% to $1 billion during its fiscal first quarter, which ended Aug. 31. Sales of "on demand" software, including software Oracle hosts on its own computers, fell just 8% to $180 million. SAP President McDermott says investors shouldn't focus on subscription sales when measuring the company, since they account for such a small percentage of revenue. The subscription deals are "an incremental opportunity to grow a net new revenue and profit stream for our shareholders," he says. "We're not a company in transition."
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