Sky Fall…ing? Supply Chain Disruption

Intuitively we all understand how new technologies can “disrupt” traditional delivery models and economic value chains.
The Internet itself is Exhibit A in this regard; just ask travel agents and bookstore owners.
Even those within the Internet industry itself — namely the gear-makers that make it all go — are not immune to the havoc of changing market dynamics.
Analysis provided by 451 Research analysts Christian Renaud, Peter Christy, and Eric Hanselman.
Emphasis in red added by me.
Brian Wood, VP Marketing

Networking sales in the software age

Cloud computing, increasing infrastructure virtualization and software-defined networks are going to cause major disruptions in the way that products are sold by traditional networking vendors.
While most of the attention is focused on competing architectures, what is often overlooked is how the resulting products will ultimately be delivered to customers. Incumbent networking vendors may see the market transition as an opportunity to develop a software revenue stream, but their legacy sales models will require a considerable overhaul to make this dream a reality.
The traditional model of networking equipment sales
In the networking industry, multiple direct, indirect and managed service sales channels are used to deliver products to customers, most of which will be challenged to adapt to this new software-defined paradigm. The first two of these, vendor direct and one/two-tier channel sales, are built on the foundation of episodic high-margin deals to compensate the sales force. Let’s look at each of these in greater detail to set the stage for the disruption on the near horizon.
On the larger-end of the continuum (Fortune 1000), vendors typically deal directly with customers via their own direct sales representatives. The same is true of selling to large carriers and other service providers that buy in sufficient volume, often disintermediating resellers or systems integrators for large hardware purchases. These large-volume deals routinely book at a steep discount off list price, effectively soaking up any margin that would have otherwise been held back as profit for a channel partner.
The direct sales reps, their technical systems engineers and the many layers of sales management are compensated on attainment of quota from sales of hardware, software and services. It is not uncommon for vendors to structure quota with a blended required minimum mix of product lines and families, and equally common for these required minimums to be completely disregarded when a sales representative attains 150% of quota on a single product family. This direct sales channel constitutes between 10-25% of sales for major technology companies.
In some countries, and certainly for sub-Fortune 1000 customers, the cost of sales is often cost-prohibitive for direct interaction because the average deal size is smaller, so channel partners are engaged. These channel partners can be simple (non-value-add) resellers of equipment purchased either directly from a manufacturer (one-tier) or via a distributor (two-tier); they may be VARs and SIs that offer professional services or software development on top of the products provided, or they may be MSPs that offer access to specific network functions (e.g., firewall, data-loss prevention, antivirus, anti-spam) as a monthly managed service. These various channels constitute the remaining 75-90% of manufacturer revenues.
For each of the direct, reseller, VAR, SI and MSP paths to market, there are different mechanisms of compensation, margin and revenue recognition. The most common form is to mark progress toward a fixed quota for each product sold, with some rather involved commission accounting on the back end once the product is booked, shipped, invoiced and paid. Product may be purchased for resale as required or inventoried at a distributor, further complicating manufacturer revenue recognition.
The key takeaway is that a sales organization has a quota, and each box sold is counted against that quota. This is a discrete, episodic event. There are often service contracts and other licenses that require annual renewal, but they are packaged as SKUs on vendor price lists and function as ‘electronic delivery’ boxes for purposes of quota accounting. This may be further complicated by a multi-step one/two-tier distribution process and how each VAR or SI compensates its representatives, but at the end of the month, the channel partner only commissions its sales force with a fraction of total margin received for the transaction and never, ever, ahead of its own revenue recognition.
For manufacturers, resellers, distributors, SIs and VARs, this makes monthly revenue ‘chunky.’ Their numbers are simply a function of boxes shipped last month/quarter/year, and there is no guarantee that past performance has any correlation to future boxes shipped. This coin-operated model stands in stark contrast to SaaS offerings, which begin with very little recognized revenue with the first customer but gradually accumulates as an annuity with each incremental customer secured. This linear growth creates predictable, less chunky (creamy?) revenue forecasts once you factor in customer growth, renewal and attrition.
MSPs are the creamy outlier in the chunky channel environment. They deploy service platforms, such as firewalls and IDS/IPS, which support ‘multi-tenancy’. Multi-tenancy provides the ability to virtually segregate customers on a single platform or virtual machine, allowing them to cost effectively over-subscribe and amortize the platform across many customers. The revenues for MSPs grow gradually as they add incremental clients to their books of business, making the managed service business financially lean in the initial years until MSPs have reached a break-even point where their monthly fees are sufficient to cover their fixed and variable costs to provide the services.
The market rewards this creamy predictability. Companies that have revenue streams that primarily consist of monthly or annually recurring software subscriptions, such as MSPs and SaaS firms, have higher acquisition multiples than chunky episodic box-centric sales companies. Of the more than 250 SaaS transactions we tracked in the 451 M&A KnowledgeBase over the last twelve months, the average multiple-to-earnings acquisition value is greater than 4x trailing 12-month revenues, which is more than twice the average for chunky box companies, which typically go for 1.5-2x revenues.
The changing software landscape
Software is nothing new to companies like Cisco, Juniper and their peers. The software that they have historically sold has primarily consisted of three flavors, embedded, support and application. All three could be impacted by new service-deployment models like virtualization, as well as licensing models in cloud and SDN environments, requiring a complicated transition in how the product is licensed and sold. Let’s dive into these three existing types to contrast them with the software-centric environment that the industry is in transition to.
Embedded software is software such as JunOS or IOS, the operating systems that power Juniper and Cisco’s routers and switches, respectively. These embedded software packages reside on the supervisory modules or line cards within the chassis and instruct the high-performance ASICs how to behave vis-à-vis policy and filtering rules. This software is purchased as a bundle with the hardware platform and has a perpetual software maintenance model, wherein customers pay each year for bug fixes, technical support and upgrades. As customers deploy more virtual switches, such as the Cisco Nexus 1000v, the average selling price to the customer goes down, as does the commission to the sales representative. This is good for Cisco because software has a considerably lower cost basis than hardware, but the lower average selling price equates to less quota retirement for the sales representative for the same amount of effort.
Support software provides for management of the hardware these companies sell. If you purchase a Cisco Call Manager seat license for your new IP phone or use Juniper’s Junos Space Platform, it will be sold to you as a package with an annual software support subscription fee, like embedded software above. This software is optional in the operation of the network, whereas the embedded software is mandatory. The percentage of Cisco and Juniper revenue that is support software is minimal (~5%). In the early 2000s, the inside joke at Cisco was that the network management P&L groups contributed less revenue to the bottom line than the company store selling t-shirts and coffee mugs to visiting customers and employees.
The final category is application software from these vendors. Applications include functions like WAN optimization, firewall and VPN concentrators. These applications are increasingly being abstracted by smaller vendors to reside on virtual machines on application blades in vendor chassis, or on x86 blades in server platforms. This is the fastest-growing category of software sales for traditional network vendors, and companies like Juniper and Cisco are constantly acquiring additional new application startups, such as Cisco’s acquisitions of Cognitive Security and Joulex earlier this year. These applications are initially brought in on their legacy appliances (if applicable) then migrated to blades on existing router or switch platforms. This allows incumbent vendors to ‘accessorize’ the captive installed base of empty slots with additional high-margin applications.
Note that in almost all cases, the legacy network vendors’ software solutions are sold as a one-time episodic sale, with a lesser recurring software maintenance fee. This fits cleanly into the compensation schemes of their channel and direct sales organizations. Virtualization software such as VMware’s vSphere is sold and licensed on a per-processor basis with license renewal after some number of years. This license fee, when sold through a partner, is high margin given the electronic delivery and no need of inventoried equipment (and the associated cost of capital). This margin is analogous to the margin ‘kick’ that channel partners receive when selling high-dollar routers or switches and, therefore, is easily digestible by traditional networking sales channels.
Where you begin to see strain in traditional sales models is with monthly, usage-based, software-subscription models like those employed by cloud service providers such as Amazon Web Services (EC2 and S3) and managed service providers such as AppRiver and Logicalis. These service providers sell storage capacity, compute resource (essentially time-sharing a server or bank of servers), or other applications such as email or firewall.
The margin on software subscription models is tricky to model as a channel partner. If the channel partner is offering the service directly as a managed service provider, it has a specific quantity of users/revenue required to break even on the fixed and variable costs to offer the service. If it is reselling a service, such as one from a Master MSP like Ingram Micro’s Services Division, it receives a portion of the customer’s monthly subscription fee as an ongoing commission. Sometimes the service providers structure the channel sales compensation as a perpetual commission for the duration of the customer subscription, but more often twilight it after an initial one to two years.
Software-defined networks are a final potential disruptor because SDN can employ a hybrid between traditional networking equipment, virtualization and cloud pricing models, depending on the vendor. The closest SDN to traditional box sales would be an HP OpenFlow-enabled switch and controller sale where each component is sold discretely with an annual software subscription. A second SDN model is one such as Cumulus Networks, which sells its software as a license annually on top of merchant silicon switches based on capacity of the switch, similar to a virtualization model. Both of these models result in episodic, large-commission sales. SDN is still being fleshed in, however, and also contains innovative models such as those from PLUMgrid or Nuage, which charge for their virtual networking functionality on a utilization basis like SaaS.
These models result in a small annuity revenue stream as providers grow their subscriber bases over time and thereby avoid the episodic revenue/commission ‘kick.’
Migrating partners and revenue
Networking is evolving to a higher percentage of virtualized services (including routing and switching), hybrid public/private cloud networks, and now various species of software-defined networks. Major vendors are already beginning to feel the heat to adapt their legacy licensing models and are responding with their own takes on licensing their legacy episodic sales in this dynamic, virtual utility-pricing landscape.
In January, Juniper announced its Juniper Software Advantage, a clever licensing scheme for management and application software that decouples the software from the hardware. In essence, a Juniper application, like a firewall, can be migrated from a purpose-built appliance to a blade within a chassis or a virtual machine within a server cluster, all under the same software license. This breaks the traditional model of embedded software and applications being tethered directly to their physical instantiation (appliance or blade), disrupts the traditional rip-and-replace upgrade cycle, and moves Juniper’s growing application business from a box model/margin paradigm to a managed perpetual service licensing paradigm.
This first step from Juniper is important for a number of reasons. In licensing network functions and management as a service, Juniper is changing the economics for customers from an episodic, capital expense to a recurring, operational expense. There are many financial benefits to the customer, including fewer ‘step functions’ that occur when you have to rip and replace boxes for newer boxes or virtual machines. This model also provides flexibility for customers to deploy these applications and services in whichever form factor best suits the needs of their businesses without having to consider capital expenditure to shift platforms.
That said, the impact on the sales process is considerable. This new flexibility for customers translates to their sales representatives no longer retiring portions of their multi-million-dollar quotas by selling five-figure Juniper NetScreen firewalls (for example), but, rather, licensing the same firewall functionality across whichever hardware platform best suits the customer’s evolving environment at a small monthly or annual license fee. Their average deal size will shrink from chunky boxes to creamy services. The entire chain of sales representatives, systems engineers, sales management and others in sales operations will require new commission and compensation plans. These plans will be hybrid at first, a blend of chunky boxes and creamy licenses, while the transition gradually occurs over time.
While this type of blended compensation scheme is difficult to design, implement and enforce for a direct sales force, it has even greater ramifications on the channel. Resellers and SIs depend on the one-hit margin kick from box sales to make rent and payroll for non-commissioned employees. As noted above, the business model behind managed services has a long runway before reaching break-even, and requires that the provider have enough capital to pay expenses until the subscriber base is sufficient to cover expenses. Transitioning traditional ‘box pusher’ resellers and SIs to an annuity services and licensing revenue stream will require that they carefully, slowly and deliberately migrate their sales compensation schemes, and operational expenses, to this new model.
Sales representatives and management have also built their lifestyles around this high-dollar income stream. Explaining to a sales representative who makes five/six-figure income per month that the company wants to shift all sales to a repeatable annuity software business is no easy task and requires that the salespeople convert from hunters into farmers. In this case, it creates a rift between the best interests of the sales organization (maximizing short-term income) and those of the company (maximizing long-term, predictable, high-margin software subscriptions). Sales representatives are ‘coin operated,’ so unless organizations are willing to mandate and enforce quota composition that leans more in the direction of software subscriptions and blend in incentive programs that don’t require their hunters to move from feast to famine, expect the sales representatives to continue to sell high-dollar/high-margin/high-commission boxes and ignore the service offerings whenever possible.
A light at the end of this tunnel is that companies like Cisco and Juniper have business functions that provide financing to channel partners. This transition to a higher mix of services and licensing provides these organizations the opportunity to craft programs to bridge the financial divide between periodic high-margin deposits to ongoing small-revenue subscriptions. Cisco alone has 70,000 partners consisting of 310,000 employees that could see their monthly commission checks impacted. The real risk is that companies like Juniper and Cisco mismanage this market transition and end up alienating the channel partners that provide roughly 80% of their revenue. The long-term upside of a predictable annuity model for these vendors is inarguable; however, the short-term danger of losing channel wallet share is very real.