Clicking with On-Demand Software Stocks

S&P's Zaineb Bokhari explains which players are taking the early lead in this new and growing market

Delivering software over the Internet, known as on-demand, is catching on with traditional sellers of corporate applications. Last week, SAP (SAP) announced that it would begin a subscription service for its customer-relationship management (CRM) offering (see BW Online, 2/2/06, "SAP Gets On-Demand Religion"). It's taking on the leader in on-demand software, (CRM), which has seen its stock rise nearly 128% since it went public in June, 2004. "It's such a hot area," says Zaineb Bokhari, who follows certain software makers for Standard & Poor's Equity Research.

BusinessWeek Online's Karyn McCormack recently spoke with Bokhari about the on-demand software trend and her favorite way to play it. Edited excerpts of their conversation follow.

Note: Zaineb Bokhari is a Standard & Poor's Equity Research analyst. She has no ownership interest in or affiliation with any of the companies on which she writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this story.

What is on-demand software, and who are the leaders in the area?

On-demand refers to the delivery of application services over the Internet, which customers can use with minimal software installation on their end. Customers usually pay a monthly fee per user, as opposed to an upfront licensing fee. We regard this model as a further step in the evolution of software as a service. On-demand is different from the service-provider model that became popular in the late '90s because all customers are on the same version of the software and it's more cost effective for the vendor in terms of providing support for users.

Leaders in the area include and Siebel Systems, which is now owned by Oracle (ORCL). The CRM area is the most developed software segment in on-demand right now.

Why would a client choose on-demand software instead of traditional software?

We believe the delivery of software on-demand offers unique benefits to customers, including lower up-front investment, increased vendor accountability and risk sharing, greater awareness of customer needs by the vendor due to constant feedback from the customers, and flexible subscription pricing that can be tailored to customer requirements. This model is also attractive from the vendors' point of view because it provides improved visibility to the customers' needs, and potentially higher customer satisfaction and retention. Another benefit for the vendor is lower development and support costs because it uses a single version of software across a vendor's installed base.

Is this segment growing faster than traditional CRM software?

Most definitely. Generally, while traditional CRM is projected to grow in the mid-single digits from 2006 to 2007, on-demand CRM could post growth in the 25%-35% range over this period. According to IDC, on-demand delivery of CRM accounted for about 6% of the $9 billion CRM market in 2005, so it's still an emerging, high-growth segment.

What are the challenges faced by sellers of on-demand software?

I think there are three basic challenges. One is customization. On-demand software lends itself to less customization just by its very nature.

The second is features and functionality. Generally speaking, on-premise software, which has been around for much longer, tends to have more robust offerings. Although vendors of on-demand software are adding features and new functionality at a furious pace. In the case of CRM, in view of the shelf-ware issues that have happened in the past, you can argue too much functionality was offered in traditional CRM software that wasn't used.

A final challenge that I think is high on people's list is application availability, because these applications are hosted in a vendor's data center. If there's an outage, customers will not be able to access the application during the outage.

Are traditional software makers buying companies or developing on-demand software?

Whenever a segment of the software market is growing at above-average rates, it attracts attention from large vendors, and on demand is no exception. Traditional software makers do have to weigh the possibility of cannibalizing their on-premise installations with on-demand offerings, while pure-plays don't.

Oracle has an on-demand business, and with the acquisition of Siebel Systems will gain additional on-demand revenue and customers. The company has mentioned on-demand as an area of future investment.

On Feb. 2, SAP (SAP) announced its on-demand CRM offering. SAP is providing the application and partnering with IBM (IBM), who will be providing the hosting.

What's the best stock to play this trend?

Right now, of the stocks I cover, SAP, which carries a buy recommendation with a 12-month target price of $57, could be an interesting way to play the on-demand trend. SAP is not a pure play by any means, but we believe that on-demand CRM could add to already healthy revenue growth that we project in 2006. We see the company's move in targeting the large and upper mid-market customers as likely being defensive, addressing the needs of its customers who might be considering an on-demand alternative to SAP's on-premise CRM software.

With its current target market, SAP does not appear to be competing directly with However, SAP has a sizable presence in the small- to mid-sized business segment. And since we consider this segment to be well suited for on-demand applications, it could be next area targeted by SAP.

When it comes to outages, has one copy of the application and customers have access to it (multi-tenant). If there's an outage, customers will experience an outage. SAP has introduced an additional layer. Under this model, which it calls isolated tenancy, a copy of the service will run on its hardware and customers will have a templated version of the master copy on dedicated servers. SAP will push software updates from the master version to the customer template. This way, SAP believes the customer will experience high availability. It remains to be seen if SAP's approach will be superior to the multi-tenant model.

What's your view of

I have a sell opinion on and a 12-month target price of $32. It was clearly among the pioneers in the on-demand CRM market. However, we believe its shares are currently trading at or near the high end of historic averages based on p-e, p-e to growth, and enterprise value-to-sales.

We continue to expect the company to grow subscribers at a healthy pace in fiscal 2006 (ended in January). However, we expect this growth to slow in fiscal 2007 as comparisons become tougher. We believe investors are keenly focused on subscriber metrics and that the shares, while down modestly from recent 52-week highs, seem to be priced for perfection. is the pure play and the current leader in on-demand CRM. It's an emerging market, and I think there will be dramatic shifts because traditional companies will come in to it and could make acquisitions in the area. It's in the early days's such a hot area.

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