September 25, 2007

The unprofitability of the SaaS business is an illusion caused by growth

There’s a fallacy going around to the general effect: is the biggest SaaS company. is making next to no profit. Therefore, SaaS is currently not a profitable business.

But that’s nonsense. Here’s why.

If you look at’s second quarter 10K, 6-month revenues were $339 million, up from $223 million the year before. Marketing and sales costs were $174 million, slightly over 50% of revenue. Profits were negligible. The company says the churn rate is negligible, so that 50% of revenue was spent increasing sales by 50%.

Now let’s suppose that the SaaS (Software as a Service) industry becomes more mature. 1% would no longer be a realistic churn rate. Let’s suppose it instead goes to 10%+, based on both true replacements and client disappearances. Let’s suppose the revenue growth rate settles down to somewhere in the teens. Bam. To a first approximation we can whack marketing and sales by a factor of 2, and take pretax margins well over 20%.

Of course, things aren’t really that simple. It’s also necessary to market and sell for customer retention. And true marketing cost (as opposed to sales) isn’t closely tied to the number of opportunities you have. But on the other hand, as you grow there are all kinds of economies of scale too. So to a second approximation, 25 – 40% pretax margins don’t seem unrealistic.

So how profitable can a recurring-revenue computer services company be? Two examples come to mind quickly – Automatic Data Processing and Paychex. ADP’s main business and Paychex’s whole business is services in the area of payroll processing and human resources. Paychex reported 39% pretax margins on its latest 10K, while ADP’s figure was in the 25% range. (Incidentally, it seems that ADP is a partner for ByDemand.)

ADP and Paychex actually tend to get much less revenue per client than, say, SAP’s ByDemand “please don’t call it ERP” system would, yet they manage to generate substantial levels of profitability. So even if we didn’t have the hard evidence from cited above, it would be a good bet that nicely profitable business models exist for SaaS offerings sold to smaller clients.

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