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Well, before we talk about the money-making process, let’s try and understand the key business drivers of the technology industry. And by technology, I’m referring to Computer Software and Hardware (excluding mobile handsets/cellular phones) industry. I’ll combine the money-making process along with the business drivers.

Key business drivers of technology industry

(1) Cost of sales

For a technology company, the cost of sales is fairly low. The Cost of Sales include

• Cost of technology upgrades (including cost of development). Usually the upgrades are released every year.
• Cost of hardware refresh: Usually, most of the technology companies have an enterprise wide agreement for their server and storage upgrade [like IBM (NYSE: IBM), HP (NYSE: HP), Dell and Oracle (NYSE: ORCL)] and networking equipments upgrade like Cisco (NASDAQ: CSCO). The refresh period is usually 3-5 years.
• Cost of documentation, duplicating software, training, packaging (if media is supplied) and cost of maintenance (predominantly data center maintenance other than what has been specified in ‘Point b’ above): Now-a-days, most of the companies enable software download feature to avoid costs associated with documentation and media.

These three costs account for 15-20% of the sales revenue, leaving 85% for Selling, General and Administrative Expenses (SG&A), Marketing and Research & Development (R&D). Hence, it’s not surprising to see Technology companies investing handsome amounts in Marketing and R&D. To give you a perspective, in FY11, Oracle invested $ 4.5 billion in R&D. With $ 35.6 billion in total revenues, that’s 12%, a good investment for Oracle.

(2) Customer acquisition

A technology company writes a piece of code once and sells the same code to each and every customer. Hence, the company can make a huge profit by a good customer acquisition strategy. More customers, more profit! Most often, we see them doing so by hiring a sales force at 50 : 50 (fixed : variable) compensation structure, with Executives remunerated with stock options for the variable component.

Also, can be seen is the Channel Sales Operating Strategy, which phenomenally reduces their customer acquisition cost, but increases their market outreach and sales. This strategy proves to be beneficial to the local customers as well. Oracle India generates 85% of its sales through its Partners.

(3) Investments

Unlike manufacturing companies, technology companies invest a small portion of their sales in Property Plant and Equipment (PPE). The only investments they usually make are

• the real estate: appreciating land and buildings, most of it will be on lease, and
• the equipments – depreciating computers (predominantly servers, desktops and laptops) and its accessories.

For a large established technology brand, the cost of such investments will be fairly low (as compared to its small industry participants) because they enjoy more bargaining/negotiating leverage. Hence, their cost of sales is further relaxed (as a percentage of total revenue).

To increase the employee productivity, the technology companies offer nutritious food from well-known caterers within their campus such that their employees do not have to head out during meal hours. In other words, resource utilization is high. Google is one such company.

Additionally, most of the technology companies offer infrastructure that harbors state-of-the-art gym, entertainment and transportation facilities. This actually increases employee productivity to a great extent. It also serves a good reason for talent retention. So, when we add these factors (employee productivity and talent retention) to the revenue, it translates to a huge economic benefit.

Considering the above, it’s not uncommon for technology organizations to earn an operating profit of 35% – 40% of sales. This is a good margin for a large public company.

Growth strategies adopted by technology companies

Let’s discuss some of the strategic growth initiatives adopted by some of the players in this industry.

(1) Channel sales

As mentioned above, Channel Sales is an operating strategy, where the player aims for a symbiotic relationship by leveraging the Partner’s skill-set, market presence and customer relationship for its sales. In India, Oracle generates 85% of its sales through a network of 1,400 partners (VAR, VAD, SI predominantly), Tata Consultancy Services (BSE: TCS) being its largest System Integrator (SI) and Value Added Reseller (VAR).

Another channel sales operating strategy adopted by global players is the bundle offer / packaged application. Most of the technology companies have a tie-up with their industry peers through an enterprise-wide agreement for mutual benefit. For example, Oracle has a global partnership agreement with SAP AG for its database license, wherein SAP charges its customers as a percentage of the application license for the Oracle database. Oracle receives a royalty for each and every sale that SAP makes from SAP-Oracle bundle sale, thereby generating revenue without any sales effort. All the support, implementation and training will be SAP’s responsibility (unless the customer opts for otherwise).

(2) Mergers and acquisitions (M&A)

M&A is one of the growth strategies, primarily adopted because of synergy and faster access to the market. In the last decade, Oracle had invested more than USD 40 billion in about 90 acquisitions. Starting as a database company, Oracle diversified its offerings by entering into the application and the middleware spaces, but later, when faced fierce competition from its rivals [SAP (NYSE: SAP), IBM and Microsoft (NYSE: MSFT)], it adopted the inorganic growth strategy – M&A – to enhance its product lines, enter new markets and strengthen its presence in the respective market segments. Some of its major acquisitions include PeopleSoft, JD Edwards, Siebel and Agile in the application space, and BEA and Sun in the middleware space. Hyperion and Siebel Analytics increased its Business Intelligence market share. Today, Oracle secures a position in the “LEADERS” of Gartner Magic Quadrant for BI and Analytics Platforms (FY2015).

Sun acquisition allowed Oracle to become a player in the hardware, storage and operating system arena. Sun hardware boosted Oracle Database and Middleware sales through products like “Exadata” and “Exalogic” respectively. Overall, Sun acquisition worth USD 7.3 billion was a strategic move such that Oracle becomes one of the largest enterprise software and hardware companies in the world.

With BEA customers added to its install base, Oracle generated significant portion of its application server revenue through migration strategy (compelling BEA customers to move to the Oracle product stack).

(3) Government rate contracts: This strategy includes signing-up contracts with government and nodal agencies, wherein any Ministry can procure Oracle license through a pre-negotiated rate contract. In India, Oracle has a rate contract with NICSI (National Informatics Center & Services Incorporated), a nodal agency that serves as a procurement arm for the Ministries.

Risk that technology companies face

Three most important risks a technology company faces that impacts their revenue are:

(1) Unexpected changes in revenue due to technology innovations from unanticipated competition. One such example is Apple’s iPhone. The innovative technology used in iPhone destroyed Nokia’s market share, which eventually led its acquisition by Microsoft. Five years before, Nokia commanded more than 50% market share globally.

(2) Unexpected changes in costs from those budgeted, especially because of employee turnover. Unexpected development costs may inflate because of more rework than anticipated, particularly due to privacy invasions, copyright infringement and security holes. Any litigation issue related to infringement and failed implementation can add dramatically to the cost. Example that I can think of is SAP-Oracle legal battle in copyright infringement case, which costed SAP $ 1.3 billion.

(3) Intellectual property: Technology companies’ biggest assets are their intellectual property like patents, copyright, license and trademarks. Even though they try to restrict access, leakage or spread through various agreements like NDA, these can be vulnerable to easy breach and infringement.

Future outlook of the technology industry

Executives are in constant pressure to increase shareholders’ value. To maximize their returns, they are always vying for efficient business processes, ways to keep a check on their costs, and greater customer satisfaction. This led the demand for technology to rise (the demand side), and so is the mushrooming of the vendors (the supply side). To get an edge in the industry, companies are always on the hunt for new ideas and solutions. This led to the advent of the one of the most acclaimed technological advancements in the industry – the Cloud Computing.

Cloud Computing is a large pool of inter-connected resources that perform similar functions. This networked pool of resources, loaded with advanced technology, provides customers a fault tolerant, agile, high performance platform with flexibility and scalability at a nominal subscription fee. Public Cloud Services boast of converting the up-front Capital Expenditures (CapEx) to Operational Expenses (OpEx).

Cloud Computing was applauded by the industry since the infant, the small and the new entrant can use latest technologies at a very low cost (subscription fee as a percentage of the total sales), without any CAPEX. In India, this fee can be significantly low – new bees are always ready to sign-up a long-term contract at a substantially low fee. With this invention, giant players like IBM, Microsoft, Oracle, Google (NYSE: GOOG), Linkedin (NYSE: LNKD), Facebook (NASDAQ: FB) and AOL (NYSE: AOL) started spreading their arms with innovative ideas and business strategies to acquire new customers.

Gartner forecasted a growth of 18% in FY13 to $131 billion for the public cloud services market. As we can see from the exhibit below, out of the 3 broad segments (cloud advertising, BPaaS, application services), cloud advertising contributed nearly 50% to the total public cloud services market, followed by Business Process Services (BPaaS), Software as a Service (SaaS), Infrastructure as a Service (IaaS), Cloud Management and Security Services and Platform as a Service (PaaS).

Exhibit: Public Cloud Services Segments (%) in FY12

North America accounts for 60% of these services, followed by Europe (24%). The highest growth rate is contributed by the emerging economies with the Asian markets (Indonesia, India and China) leading the growth trajectory. Analysts are optimistic about Europe’s performance, but will settle with 10% short-term growth due to the economic slowdown.

In a nutshell, with cloud computing, the technology industry will witness a growth trajectory for at least another 10 years. Hence, the future outlook of it is positive and is a must watch for any non-accredited, accredited and sophisticated investor.

You may also want to read my article Key metrics that reflect technology industry’s fundamentals here.

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