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RESEARCH & ADVISORY Application Software Vendors Sept. 20, 2007

Beyond the Midmarket – SAP Bets the Future on Business ByDesign

MGI Analytical Team

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On September 19, 2007, SAP AG unveiled Business ByDesign

("BBD"), its long-awaited "on-demand", software-as-a-service

(“SaaS”), entry in the enterprise application market. The initial

description of BBD sets it apart from most other competing of-

ferings - both proprietary and open-source, and our initial ref-

erence checks confirm this (See MGI Research’s “Interview with

BBD Beta”). When completed and delivered, BBD aims to domi-

nate the applications software market for small and medium

sized enterprises and lets business people operate and manage

the product rather than rely on IT organizations.

Positioned as a product for midsize companies with 100-500

employees, Business ByDesign (formerly referred to as A1S) is

much more than that. It is clearly the next-generation, "bet-the-

company" product for SAP. SAP stated ambitious goals for BBD:

$1 billion+ in revenues and 10,000 new users by 2010. In our

view, SAP will likely fall short of its aggressive targets. The com-

pany does not yet have a dedicated re-seller channel for BBD

and building up a network of re-sellers, data centers and servic-

es specialists will take at least 24-36 months. BBD is also a high-

ly proprietary product that is in Beta test and pays limited lip

service to the "open source" hot button of many IT users. How-

ever, BBD is arguably the biggest announcement in enterprise

applications of this decade. It has major implications for the en-

tire industry and for SAP customers and investors. BBD

represents a polar philosophical opposite to SAP's key competi-

tor Oracle’s world view of business applications, - a view cen-

tered on economic consolidation rather than SAP’s drive for

technological breakthrough.

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MGI Analytical Team



The BBD announcement signals a new playing field for large application software providers - an environment

that is akin to car and computer hardware companies that can be defined by the technological race for engineer-

ing superiority. The new BBD product has both a new framework and a new and complete set of enterprise ap-

plications that are scalable, connectable and in fact in a page taken from Microsoft strategy, subsumes many of

the functions previously provided by separately sold third-party products. It remains to be seen if the mid-

market and small business customers will see the SAP's value proposition in the same positive light.

SAP is betting the company future on BBD and moves the minimum standards and goal posts of business soft-

ware applications to a new level for the entire software industry. SAP is the first large incumbent software ven-

dor to announce such a broad set of business application functionality available on-demand. BBD aims to give

business users actionable information, rather than a transaction processing system. The last time SAP an-

nounced such a transformative product was the launch of R/3 – which is by far the most successful ERP product

in history. SAP’s intent with BBD is to deliver a broad array of enterprise-wide functionality (financials, manufac-

turing, supplier relationship management, CRM, BI, project management, etc.), at a price that compels the users

to change the status quo. In another analogy to Microsoft, this is what Microsoft Office did to the stand-alone

desktop productivity applications – over time customers will question the need to spend incremental dollars

with a wide-array of software providers (BI tools, report writers, process modeling tools, et al) when they can

get it all from SAP.

Market Impact While BBD will generate lots of industry buzz, it is unlikely to freeze the market in 2007, and

even into the first half of 2008.

• Users looking to implement an enterprise wide solution in the next twelve months should carry on with their

plans, as we do not expect BBD to become operationally stable for another 12-18 months.

• Only the most hardcore leading edge companies with generic business processes should consider BBD through

1H08.

• We see little to no impact on Oracle through its 2008 fiscal year.

• Looking out 12-24 months, BBD has the potential to be a major force in the market. Infor, Microsoft, Netsuite,

Epicor, IFS, and QAD, among others will be impacted by SAP’s BBD. Upstart open source ERP and CRM solutions




MGI Analytical Team



like Compiere and SugarCRM will be forced to compete on more than “low TCO enabled by open source”. The

competition is now on notice, and will have to respond by the first half of 2008 or risk being left in the dust. Ap-

plication software vendors lacking stand-out vertical industry capability (e.g., QAD in Tier 2/3 automotive) or

departmental/business process expertise (e.g., Salesforce in sales automation) will be gasping for air as SAP

sucks the oxygen (and money) out of their markets.

SAP’s potential to succeed is undeniable.

1) SAP is one of the few software companies to be successful in more than one era of computing. There are few,

if any, technology companies who have successfully transitioned from one era to the next. SAP was strong in

mainframe business applications (R/2), and globally dominant in client/server business applications (R/3). The

same team that made R/2 and R/3 a global success (notably Peter Zencke and Gerhard Oswald) led the BBD

team. Combined with SAP's already considerable investment and the fact that this is the first time the company

has made such a singularly bold announcement since R/3, it is clear that project Business ByDesign (“BBD”) is the

true progeny of R/2 and R/3.

2) SAP has the patience and resources to invest for the longhaul. 200-400 million euros is a substantial commit-

ment, and SAP has proven to be much more patient than its competition. Only Oracle, Microsoft, and IBM could

match the financial commitment of SAP – and none has shown the intent to take such an approach.

3) SAP is making a very deliberate strategic choice. They have decided not to go the M&A consolidation route,

have not pursued growth in services (although it would be a path of least resistance), and they are not going into

horizontal technology (and have historically stayed away from it).

4) SAP brand equity is strong, it has global reach, and deep expertise in business processes. SAP knows business

processes better than any other major software company (although Oracle is closing that gap). SAP is leveraging

its strong reputation to enter a market that historically has been filled with opportunistic, unsophisticated soft-

ware vendors. The company has spent millions on an ad campaign during the past ten months, raising aware-

ness for its SMB efforts.

5) SAP’s competition can be divided into two segments – the SMB incumbents, and the traditional applications

software market opponents led by Oracle. The incumbents with on-demand solutions are an easy target for SAP.




MGI Analytical Team



It is full of under-capitalized, software companies that struggle to articulate their ROI proposition. A number of

the mid to large size players in the SMB apps market, e.g., Infor and Sage Group, are an amalgamation of un-

connectable legacy products more focused on maintaining a reliable stream of maintenance revenues than deli-

vering break-through innovation.

On the other hand, SAP’s success is not guaranteed.

1) The SMB market is fundamentally different than SAP's core business. SMB customers are a) very price sensi-

tive; b) have few, if any, tech resources; c) are not tech savvy. This is the exact opposite of SAP's traditional

sweetspot – large sophisticated enterprise customers with competent, well-staffed IT organizations. The corpo-

rate genetics of SAP are counter to what makes a successful SMB software vendor.

2) Business ByDesign is just the latest in a long string of mostly unmemorable SMB initiatives by SAP, further

convoluting SAP’s already complex product line up. SAP has done a decent job positioning its offerings in an at-

tempt to avoid overlap and cannibalization. However, the current SAP product line-up will need to be rationa-

lized -- e.g., should a midsize customer buy SAP Business One, SAP Business All-in-One, or Business ByDesign?

BBD is receiving the lion share of investment funds and resources – Business One and All-in-One customers will

need to take that into consideration before making additional commitments to those products. Furthermore,

many large SAP customers also have small and midsize operations not currently using SAP products. If they

chose to adopt Business ByDesign, how will those implementations integrate into their large, complex, global

SAP system?

3) BBD is neither cheap nor easy. At $125/user for a minimum of 25 users, that works out to $135,000 for three

years. Most organizations will need to license 50+ users. Even at $135,000 many SMB’s will find they can pur-

chase applications that are “good enough” at the same or lower cost (even when you include hardware, imple-

mentation, etc. With impressively complex plumbing lurking just below the surface of BBD, it’s reminiscent of

early R/3 days when a German dictionary and ABAP programming skills were highly recommended for the early

adopters installing the product.

4) Enterprise applications are not trivial (as SAP well knows), and the launch event was short on pragmatic de-

tails. For example, how will customers migrate their data? Who will do the business process consulting? Are cus-

tomers forced into the SAP reference models for industries and business functions? It’s relatively easy to offer a




MGI Analytical Team



single business capability/process on-demand (e.g., sales lead management/customer tracking, HR application

management, web conferencing). Configuring an enterprise-wide system, loaded with clean data is a much big-

ger challenge – even for a relatively small company.

5) To quell the doubters, SAP will undoubtedly refer to its history and its engineering prowess. Its current mar-

ket-dominating product, ERP 6.0 (nee R/3), they will insist, was originally intended to be the “little brother” to

R/2. It has matured into the most scalable packaged application in the market. SAP has thousands of Mittelstand

(German mid-market) customers today, further proof that the company understands the SMB market. And SAP

will quietly remind its critics that there was no migration path from R/2 to R/3. R/2 customers had to purchase

the system anew and undergo an often lengthy and complex implementation of R/3. In spite of these draw-

backs, SAP rocketed to the top of one of the largest, fastest-growing segments of the IT industry during the

1990s. Yet, these are different times today and there are many more choices available to customers. Translating

a triumph in the German middle market into a global success may prove to be tricky.

Key Issues and Milestones to Watch

1) Will current SMB customers find BBD compelling enough to leave their current software vendor(s)? No cur-

rent SMB competitor (including Microsoft, Infor and Salesforce) can deliver as much enterprise-wide functionali-

ty and innovation as SAP. Nonetheless, the 10,000+ installations of IBM AS/400s (“iSeries”)-based applications

are a testament to the conservative, cost-conscious nature of mid-market users who prefer lower risk, proven

solutions.

2) Will SAP assemble an ecosystem of SI’s and VARs who will base their entire business around BBD?

3) Will the margins for BBD be the same or better than SAP’s traditional margins? Put another way, can SAP tap

into profit margins in the on-demand market that others (Salesforce, Netsuite, et al) have found elusive?

4) On the product front, will BBD scale and perform as promised? As Salesforce.com has learned the hard way,

keeping a system up 24/7 is not easy (and they are only dealing with a CRM system, whereas BBD wants to cover

the entire range of enterprise transactions). SAP glossed over the complexity of running an on-demand business.

Power costs alone could be a material drag on SAP’s operating costs.




MGI Analytical Team



5) Does the intense focus and investment on BBD imply that SAP believes the high end of the market is satu-

rated, and its potential to derive revenue from customer migrations to Netweaver (the SOA-enabled version of

its flagship product) is limited/exhausted? Even assuming that it can drive high-end migrations, can SAP realisti-

cally manage the upgrade process for 15,000+ current customers while simultaneously “creating a new business

model and a new market” in the words of CEO Kagermann?

6) From 2009 and beyond, why wouldn’t every new and existing SAP customer (regardless of size) implementing

a new system subscribe to BBD. We believe it is highly likely that BBD will surpass all other SAP products in new

sales in 3-4 years, just as R/3 eclipsed R/2 about three years after its market introduction.

7) BBD will be the defining legacy for the current SAP management team, most of whom have been with the

company for 15+ years, and will likely retire within the next 5-10 years. Will they bask in the sunset glory of their

careers, revered as the fathers of BBD, or will they slink into the background, much as Jim Allchin, leader of the

Microsoft Vista team, has done?

Additional notes: MSFT - having acquired multiple products in the SMB enterprise applications market, sub-

sequently invested heavily in product integration, and unleashed the full force of its army of consul-

tants/implementation partners - has not been able to see a return on its investment in SMB enterprise applica-

tions.

Salesforce.com has been successful with a vanilla, universal application that requires virtually no training and no

implementation time. Founded in 1999, Salesforce breezed past $600 million in revenues and are tracking to $1

billion (and curiously have a low single-digit ROE, and a four-digit P/E today). It has taken them eight years to get

where they are. Analysts are predicting SAP can build a $600 million business in three years.

Netsuite, founded in 1998, is on track to do about $100 million in revenues this year, has never made a profit,

and has an accumulated deficit of $193 million. The company is majority owned by Larry Ellison, not exactly a

tech industry neophyte. With its S1 filed, the timing of SAP’s announcement could not have been worse for Net-

suite.

Bottomline: BBD will be the most closely watched applications product of this decade. SAP aims to set a new

bar for enterprise applications. The hype and expectations are equaled only by the amount of potential execu-




MGI Analytical Team



tion risk – implementation issues, market adoption, channel development, performance and scalability risks -

the list goes on. The next 12-18 months are crucial for SAP in terms of establishing traction and execution proof

points for BBD. The results should serve as indicators of SAP’s ability to remain a leader in the applications soft-

ware player space.


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