Cisco recently announced it would cut 5,500 jobs as part of its restructuring; Intel, Dell, and other tech firms have cut around 63,000 employees this year alone. While the trimming of a bloated workforce is a good thing, broad, deep cuts such as these are indicative of a seismic shift in the tech industry.
IBM was early on this trend, having sold their PC line to Lenovo back in 2005 to focus on their software offerings and Cisco’s move to cloud services contributed to their announced headcount reduction.
These substantial shifts represent both the fallout and the next steps in the move from a hardware-centric focus of older tech companies to the software-oriented champions of tomorrow’s tech industry.
Changes like this don’t come out of anywhere, so what’s behind it? It is due, in part, to the maturity of the hardware industry. More competition in the field over the past two decades has driven down costs along with profit margins. Large consecutive leaps in hardware capability are required to maintain margins on hardware at profitable levels.
Without these jumps forward, many customers see little benefit to perpetually upgrading; they believe what they have currently as “good enough,” bad news for hardware designers and manufacturers, as the cost of sales increases.
Another driving force behind this change is the significant improvement in Internet connectivity over the past decade. With soaring data transfer speeds, what was once essential hardware functionality can now be offloaded to specialized providers, allowing enterprise customers to focus on their core competencies instead of spending valuable resources on in-house tech expertise.
The benefit of Software over hardware
Software solutions allow for readily recurring revenue through a subscription model and, as any business strategist will tell you, it is considerably less costly to retain customers than it is to gain new ones.
This change in concentration from hardware to software has its benefits. For one, founding a software company is considerably less expensive than a hardware company. In a hardware venture, first, the product must be designed, then prototyped, then manufactured at a large enough scale such that costs can be recovered, then distributed.
Software companies, on the other hand, could theoretically be started by someone with nothing more than a computer and programming know-how. Meaning headcount can be kept fairly lean, keeping costs down, and allowing for an extremely efficient company when measured regarding value generated per employee.
Once a piece of software has been built, it can be sold over and over again at virtually no cost. With digital software distribution becoming the norm, even the costs of installation media have been removed – in fact; they are borne entirely by the consumer. When the product is ready for market, it generates pure, unadulterated cash for the company as it sells. Of course, this ignores R&D costs for future improvements; this expense would be required for a hardware company, as well.
These lower expenditures promote growth. A lower cost base means cash flow positive is easily achieved, as profit margins tend to be much higher for software companies than hardware, allowing more money to be invested back into the business, driving growth organically. Organic growth reduces the need for outside capital, allowing founders and early shareholders to retain control of the company’s direction and culture (not to mention the upside potential).
SaaS looks like an even better deal today
In today’s yield-starved environment, high margin, high cash flow businesses with solid growth prospects receive stratospheric valuations, explaining the multitude of unicorn companies found today, whose count has hit 170, with a total market capitalization of $620 billion. Furthermore, this underpins the reality of today’s active technology M&A market.
The ROI on the acquisition of a software company that complements the acquirer’s business lines is much higher than investment in traditional CapEx, at least according to the interest rates in the corporate bond market.
Overall, this shift from hardware to software in the high-tech industry is value-positive, helping the sector not to fall behind or grow stale and has paved the way for small companies to be started at low cost and grow phenomenally fast, because of their subscription-based revenue streams and practically non-existent distribution expenses.
All this leads to sky-high valuations and a very active merger market. Of course, none of this would have been possible without the advancements in hardware over the past 20-30 years, so the software titans of today, while wildly successful in their right, are standing on the shoulders of giants.