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Tech Industry

A hard turnaround for software

Software companies caught in a downward spiral find it exceptionally difficult to escape. Yet a determined few succeed.

While executing a turnaround in any industry can be a difficult task, digging a software business out of trouble is a Herculean one.

Certain product, financial, and labor market forces unique to the sector reinforce one another when a software company is performing well--and also when things start to go wrong. With the right formula, companies can ride a wave to fantastic success. When the environment changes, they must battle mightily to avoid being sucked into the abyss.

The odds against turning a software company around are thus extremely high. A McKinsey study showed that out of 492 companies defined as struggling, only 13 percent were subsequently able to revive themselves--an unusually low proportion. Yet turnarounds are possible, and the rewards make the effort worthwhile.

Why is it so difficult?
Software turnarounds are tough because, at the first signs of trouble, forces specific to the industry can combine to create a deadly downward spiral.

Take product market forces. Software is a winner-takes-all business in which three factors--the need for compatible technology in networked environments, high switching costs, and increasing returns to scale--unite to ensure that only a small number of players in most market segments survive in the long run. SAP, the German provider of enterprise resource planning (ERP) software, illustrates the phenomenon: By the mid-1990s, it was such a clear leader in its market segment that it was able to claim, "We spend more on R&D than our competitors have revenues."

This winner-takes-all phenomenon favors companies as they race toward market leadership, but it exacerbates the difficulties of companies that fall on hard times. Switching costs, for example, are high because software is expensive to integrate into corporate IT systems; this hurts the losers because once a network has been configured around new software and employees have been trained to use it, the company isn?t likely to switch to a company that might not be around to provide upgrades and service in years to come.

Forces in financial markets are another consideration. The volatility of share prices in the software sector reflects the cyclical nature of demand for information technology and, more important, the intangible nature of assets such as employees, customer relationships and technologies. The importance of these intangible assets--the essential drivers of economic value for software companies--is magnified by their scalable character and the winner-takes-all dynamic of the business. But it is notoriously difficult to price them, so investors must rely on revenue and earnings streams as proxies for their value.

Software companies benefit when their performance is rising, as their return on invested capital can exceed 50 percent and grows quickly. During a downturn, however, they are hit twice--once for their actual financial performance and again for what it implies about the value of their assets. If insolvency looms, investors flee because there are few residual assets to divide.

Finally, labor market forces contribute to the spiral. In most software companies, stock options form a large part of the employees? compensation. Once a company starts to fail, it can suffer a massive attrition of its work force as options lose their appeal. The most valuable employees tend to leave first, diluting the company?s intangible-asset base at the time of greatest need. If the company tries to hang on to this talent by increasing pay, net income suffers, thus further reinforcing the vicious cycle.

How to turnaround a software company
To escape from this spiral, a company must address huge challenges: revitalizing its core business, investing in new category killers, and ruthlessly cutting everywhere else. It must also regain the trust of financial markets by achieving liquidity, profitability, and growth. Finally, to attract and retain talent and to create a commitment-based culture and organization, the company must staff a core turnaround team and enable it to act quickly. This is a tall order, but companies such as PeopleSoft and Intuit have shown that it can be done.

During boom times, the "landgrab" mentality of most software companies drives them headlong into new geographies, products, channels and customer segments. Given the overriding importance of scale within the industry, this approach is not only sensible but also frequently imperative. When changing market conditions, strategic mistakes, new technologies, or shifts in customer demand abruptly end the boom, though, companies that have grown unselectively or neglected their core business find themselves saddled with bloated costs and with poorly defined products and services.

The first requirement for such a company is to peel back the layers it added during the landgrab phase and to locate the distinctive part of its business--the part that once made it a market leader. This is usually the core software product, along with the customer and network relationships and the customer channels connected with it. More often than not, it suffered from neglect and underinvestment as the company expanded into other areas.

A practical starting point is the use of a handful of key customers--preferably leaders in the industry--to guide the company?s redirection of its business. The loyalty of this group will also provide a base of customers who can serve as references for new business. Such endorsements are very important in software, since it is an "experienced-based" product. PeopleSoft, which suffered from overexpansion and a downturn in the ERP market in 1998, revived its core ERP business by responding to the demand of its leading customers that it replace the client-server architecture of its previous products with a new Internet-enabled product, PeopleSoft 8.

Ariba is also working with leading customers in an effort to restore itself to health. The company saw its market capitalization dive to $1 billion, from $40 billion, between October 2000 and October 2001 as the bottom fell out of the market for e-marketplaces, in which it had invested heavily. Ariba had neglected its core franchise: the provision of enterprise procurement software to help businesses manage their spending on office supplies. The company has now turned to its customers to discover what really drives procurement savings--limitations on purchases from nonapproved suppliers, for example--so that it can prioritize its R&D investments and so refine its principal offering.

Software companies targeting the broader consumer market should also examine ways to develop their core franchise. Intuit fell on hard times in the mid-1990s, when the market for consumer financial software began to mature and the company?s Quicken software for personal financial management was challenged by a powerful new competitor: Microsoft Money. After Intuit found that its customers increasingly used the Internet for financial services, it responded by investing heavily in the development of server-based financial services software through the Web. The resulting software was one of the first successful online products in the consumer and small-office segment. Because the package was quick to access and easy to integrate with online financial services, it became a great success.

Invest in the leaders
Revitalizing the core business is just the first step. Software companies also need to come up with new category killers: products that will claim a market share of at least 30 percent. As with efforts to revitalize the core franchise, senior managers should draw on the views of leading customers, analysts, and partners.

Choosing investment opportunities is important, of course, but in all likelihood the most difficult challenge for senior managers will be actually turning these investments into concrete and distinctive successes. To have even a chance of winning against specialized competitors in this highly competitive industry, a company must have tremendous financial and human resources as well as a keen focus. Most unsuccessful companies handicap themselves by diluting their efforts across a variety of growth options.

Growth initiatives can be generated internally. Lotus, for example, suffered in the late 1980s, when Microsoft Excel challenged its core franchise: the Lotus 1-2-3 spreadsheet. The company responded by investing heavily in programmer Ray Ozzie?s vision of a software platform that would foster collaboration in large networked organizations. The result, Lotus Notes, became one of the most widely used enterprise software applications in the industry?s history.

Some companies have difficulty creating growth options in-house. In these cases, mergers and acquisitions, though fraught with risk, can offer a quick way to establish a position in a new market. When PeopleSoft looked for a product to complement its ERP package, it decided that its weak position in the fast-growing area of customer relationship management warranted the strategic acquisition of Vantive, then the second-largest firm in that sphere. PeopleSoft paid $426 million--quite a sizable amount relative to its market capitalization. But the resulting marriage of customer relationship management and enterprise resource planning applications created a comprehensive e-business suite that no rival could match. Coupled with the introduction of PeopleSoft 8, the acquisition helped the company?s share price to rebound from $16 in June 1999 to $43 two years later.

An acquisition also helped revive Manugistics, a developer of supply-chain-optimization software. The company hit a low point in 1998, when its stock price plunged by 72 percent, to $12.50. In 2000 it acquired Talus Solutions with the aim of expanding into the nascent field of pricing- and revenue-optimization products and services. Manugistics built its complete e-business supply-and-demand network by integrating its original product with Talus? profitability-optimization products, which fine-tune the scheduling and pricing of processing time. That same year, the stock price of Manugistics soared to $241.

Cut ruthlessly everywhere else
Heavy investment in winning products must be paid for with cuts elsewhere. PeopleSoft, for instance, halted three of its large product-development projects, laid off 15 percent of its work force, and redirected its remaining 1,500 engineers to develop PeopleSoft 8. The same relentless focus is necessary when a company develops new category killers. Any project that lacks the potential to achieve hundreds of millions of dollars in revenue must be scrutinized and, probably, eliminated. A company that fails to make these hard decisions has a poor shot at restoring its business to health.

A software company can re-establish its credibility with investors by setting clear expectations and consistently delivering on them. The most pressing need is often to establish liquidity through a one-off infusion of cash--because where tangible assets are few, equity investors can become skittish if a lack of cash becomes an issue.

For more insight, go to the McKinsey Quarterly Web site.

Copyright © 1992-2002 McKinsey & Company, Inc.