Micro Economics catching up with Software Industry. 100 million is the new billion.

October 20, 2013.

Last 25 years for the software industry has created very large and successful companies. These companies have enjoyed very high operating margins, sometimes even as much as 70–80% for some products; have returned tremendous value to shareholders and thus resulted in getting into top market cap companies in relatively much shorter time than any other industry; have resulted in creating more billionaires and millionaires, not just the founders, than anything we have seen before. These companies have brands in top ten brands of the world and habitually show up in the list of best companies to work for.

IBM, Microsoft, Oracle, Google, Apple and related chip making companies like Intel or OEMs like Dell have all benefitted from this trend. This kind of results have to be due to a very large “Competitive Advantage” in technical IP (patented or otherwise), strong loyal technical staff and ecosystem which generates value through partnerships. There has also been network effects and switching costs in communication networks or proprietary formats.

But things seem to be changing in last 3–5 years. The pace of innovation has been unprecedented making Web or Service based offerings part of the daily life. Device innovations in UX design, SW & HW leaps like Touch while driving down prices (or at least a range of prices) have created very convenient form factors. This has put devices in hands of many more people with little to zero learning curves and they are spending increasingly more minutes on these devices making use of the services. I do not want to spend more time explaining this trend as it is well felt, we see it all around us and there are enough writings about it already. Amazon, Facebook, Google, Samsung are some examples of companies leading this phenomenon.

The point I want to get to is that even though the pace of innovation has been greater than ever, I feel we are not seeing and nor will see the same level of profitability curves / margins and stock price doubling every year kind of trend on a sustained basis. This does not mean we will not have large cap companies or there will not be stock price uptrend, sometimes even a triple digit growth for a year or two, but it not going to be for 10–15–20 years.

There are factors which are different. Firstly, an idea to implementation cycle has shortened due to all the work that has happened at platform level and the developers tools, infrastructure and help that is available. So if there is a great idea and shows traction, before one company could use first mover advantage for long enough time there are 10 new variations in the market in no time.

One could argue that the platform play may still create a sustained value but open source software provides a credible alternate which drives down the value of platform. Google has built out and caught up on 15 years of innovation on OS using Linux based open source as the core layer of the OS for Android and is driving down value of Windows or iOS. Amazon is using cost as the competitive advantage not deep rooted technology IP. This means profitability cannot be super high even for the platform providers. Good strategy with good execution will create good, large and growing companies like any other industry but not the unnatural profit margins of the fore.

Secondly, the distribution problem for applications & services has been effectively solved using the Web, Marketplaces and over the air installations. No more going to stores for buying software and a CD installation. This means as a developer one really does not have to worry about how to get the software out to the users to try out. And if a developer team wants to get it out as a service, there is enough infrastructure available for anyone to get a service up and running in no time. Amazon or Google and a whole lot of other providers provide all the infrastructure and tools to make this happen.

Thirdly, the distribution of critical technical talent in the industry is more uniform. In 80’s and 90’s a computer science grad would be looking to work in one of the large companies in US as the first choice and the best were chosen. It does not seem things are that simple anymore. Technical talent is distributed by geography, by companies and a large number is in startups. Technology startups are lot less capital intensive which means the barriers to start a company are much lessor and hence truly “garage” ready industry characteristics exist.

This lack of long term dominant profitability phenomenon shows up for example for Apple iPhones. It is a revolutionary product and changed the industry forever. But in less than 5 years lot of the pluses of iPhones show up in Samsung phones or HTC phones and a whole number of country specific companies in India and China. Micromax is an example in India. These companies have a good enough alternate with much lessor price and higher end devices which are as good. Apple is in the news always to be considering the cheaper devices to go beyond 20% marketshare (they have not done it though).

Even a long standing, and arguably one of the widest Moat in applications industry, Microsoft Office is facing a threat from a large number of me too offerings in this new environment. There are Google and Apple takes on it but that is strategic play to drive down value of MS Office in consumer mind. But more important are the large number of apps on marketplaces for addressing specific niche needs served traditionally by Word and PowerPoint. Excel is much harder to replicate but the competition there is from special purpose task applications. We could argue that this competitive pressure was always there but the changing conditions described above the changes the economics itself. It seems unlikely that MS can keep driving the same level of profitability as it has been enjoying in this space.

There is also a flip side of this phenomenon for new applications providers. It is hard to imagine that there ever will be a new offering (application) which can generate 1 bn users. If any new idea creates few million users, it is a big rage and talk of the town. That causes a whole number of new variations created due to easy tools and enough technical talent in the industry. Marketplaces allow these variations to show up in the face. User needs are never exactly the same and everyone downloads a different variation => no one app is able to even hit 30–40 million users. Now things are slightly different for network effect applications like in communications space. But not too different, just that the numbers are maybe couple of 100 million before the fragmentation happens. This is different than billion range for Office or Facebook.

So it seems, 100 million is the new billion — both for devices and applications or services. This seems definitely truly for startups and smaller companies.

Search for Google is another dominant play. But here also several phenomenon like social based search, task based apps (search fragmentation) and competing properties are driving down growth and profitability. The overall pie of course has lot of upside but it is hard to imagine the dominance & unbridled profitability of 90s and 2000s.

So it seems that the large companies will have to grapple with a move to a traditional model of developing advantage like Supply chain excellence (for HW companies), cost management (for running Services) and brand building. Technology innovations are table stakes for survival. This is closer to pharmaceuticals industry kind of model, where platform providers are the big drug manufacturers and app providers are like the commodity unpatented drug manufacturers. Although drugs industry patents are much different than software industry patents. Software industry patents are more in number but less potent as there is always another way to do the same thing in software — it is bits and bytes at the end of the day.

By no means this means there will not be a new technology which revolutionizes our lives again. There will more certainly will be, only that the competitive advantage it gives to the first mover is going to be shorter lived as new companies will come in to drive down value by creating a me too product lot sooner. Classic Micro-Economics takes over…