Netsuite IPO and the Essence of SaaS Business

Netsuite’s IPO and its Financial Data

Looking at the financial data Netsuite submitted to the Securities and Exchange Commission for its public offering, fiscal 2006 sales (period ending at the end of December 2006) were US$67.2 million with net loss reaching US$35.7 million. Its most recent sales over three quarters (January – September 2007) totaled US$76.8 million with a net loss of US$20.6 million.

A closer look at the financial data, however, shows that its gross profit margins (gross margin ratio) are extremely high. Its gross margin ratio in fiscal 2006 was 65.8%, and 68.5% over the most recent three quarters. This high gross margin ratio is on par with companies that develop and sell packaged software (for example, Microsoft, Oracle and SAP’s most recent fiscal year gross margin ratios were 79.1%, 76.7%, and 66.2%, respectively).

The primary reason for posting a net loss despite such a high gross margin ratio is because of sales and marketing costs. A look at the posted “sales and marketing” costs shows that they constituted 65.3% of sales in fiscal 2006, and ate up almost all of profits. In addition, 54.6% of net sales went into sales and marketing over the most recent three quarters.

In fact, Salesforce.com, which went public on the NYSE in 2004, has a similar financial structure. For example, fiscal 2007 figures (period ending at the end of January 2007) show a gross margin ratio of 76.1%, yet the net profit to sales ratio was a mere 0.1% and 50.1% of net sales were spent on sales and marketing.

The Essence of Saas

SaaS is a model that provides (sells) functions traditionally provided by software as services through the internet. As a concept it is no different from application service provider (ASP), which experienced a brief boom around 2000.

However, the SaaS provided by Netsuite and Salesforce.com has the characteristic of “multi-tenancy architecture”. “Multi-tenancy architecture” refers to a format where services are provided with a single instance of the software to multiple user companies. This requires that a mechanism be installed that is able to customize to the needs of user companies without altering the source code.

In the case of the single-instance architecture, software versions different among each user company must be managed, and as such an increase in user companies means a proportional increase in management costs. With multi-tenancy, however, an increase in user companies results in only a marginal increase in management costs.

In other words, multi-tenancy SaaS is a business where, similar to packaged software, “economies of scale” play a major factor. In the case of packaged software, economies of scale are a factor in the software design and development process. With SaaS, economies of scale are significant in the maintenance and operation process in addition to the design and development process.

Similar to packaged software, therefore, with SaaS both profits and “profit margins” increase along with an increase in user companies. Here we find the reason for high gross margin ratios boasted by Netsuite and Salesforce.com.

How to Address SaaS

The essence of SaaS is that because it is a multi-tenancy, economies of scale play a part in the maintenance and operation process in addition to the design and development process.

SaaS, in which economies of scale come into play in all processes, can gain an edge in terms of cost compared with traditional information systems. Put differently, information systems developed independently go without saying; even compared to information systems that use packaged software, the amount necessary to use the information systems decreases. As a result, the SaaS market can be expected to steadily grow.

In addition, the tendency towards “winner takes all” becomes stronger in the areas where the economies of scale apply. This is because the more clients a vendor has the higher its profit margins, which generates more money to spend on R&D and strengthen functions and performance. In some cases, this in turn makes it possible to drop prices lower than its rival companies. As a vendor, it is therefore important to enter the SaaS market early and expand the client-base. Here we find the reason for Netsuite’s high marketing costs.

Like packaged software, if successful SaaS can grow to become a “cash cow” that yields huge profits. Therefore, instead of demanding short-term profits, it is necessary to place it as the target of strategic investment and develop user-friendly and multi-tenancy SaaS while at the same time pursuing aggressive marketing.