While it’s clear that revenues from cloud-computing offers are rapidly growing, what is unclear is how profitable these offers will be for technology companies.
Every quarter, the Technology Services Industry Association (TSIA) analyzes the results of two tracking indices. The first is the Technology & Services 50 Index, comprising fifty of the largest providers of technology solutions on the planet, including companies like IBM, Microsoft, and Cisco. The second index is the Cloud 40 Index, forty of the largest born-in-the-cloud companies in existence. They include fast-growing companies like Salesforce, NetSuite, and Rackspace.
The data has been consistent for the past four years. Traditional technology companies are profitable, but they are not really growing. Born-in-the-cloud companies are growing rapidly, but they are not profiting.
What Does it Mean When Cloud Companies Are Not Profitable?
Investors have been rewarding fast-growing yet unprofitable cloud companies. The reason? These companies represent the future of technology spending. These companies are capturing market share. And with scale, the belief is that these companies will eventually become profitable, especially when they trim back their intense spending on sales and marketing intended to capture market share.
There is no doubt technology spending is shifting toward “as-a-service” offers. However, more revenue for cloud companies is not automatically translating into higher profitability. Oracle was profitable at $50 million in annual revenues. In the Cloud 40 Index, there are 24 companies with annual revenues over $100 million and negative operating incomes. More disconcerting, many of these companies are spending a greater percentage of revenue on sales and marketing as they grow — keeping profitability at bay. In addition, the gross margin on subscription revenues is not demonstrably improving with scale for a majority of these companies. Finally, we are witnessing intense commoditization of almost all technology features.
The Path to Profiting in the Cloud
Clearly, the future of the technology industry cannot be centered on unprofitable business models. Scalability is not a given path to profitability. For cloud-computing providers to be profitable they will need to pursue a few crucial design principles.
First, their offers will need to be anchored on delivering specific business outcomes. Technical feature functionality alone will not unlock the margins that technology companies are historically accustomed to achieving.
Second, customer engagement models will need to successfully help customers adopt solutions. Traditional technology go-to-market models are optimized to land customers, install the technology and service it, if it breaks. A profitable cloud requires customers that actually consume, expand and continue to renew their subscriptions.
Finally, the economic engines for many cloud providers will need to diversify. For example, traditionally, software-as-a-service companies realize 70 to 100 percent of their revenue through technology subscriptions. To maximize profitability, these companies will need to monetize and grow value-added account services that help customers achieve their business objectives.
Editor's Note: This blog was originally published on 2/14/2017 and was updated on 5/30/2019 with current information.