Electronics manufacturers are rapidly shifting their product focus from the purely hardware-centric offerings that have characterized the industry for decades to software and subscriptions services that are growing faster, produce higher margins and foster longer-lasting relationships with customers. In fact, as product commoditization spread through the market as a result of the entrance of new lower-cost players, Western OEMs in particular now see their future success as being tied to the ability to complement hardware products with a greater amount of software offerings.
Cisco Systems Inc. is a perfect example of this hardware-to-software shift. The company’s goal is to generate a larger portion of its revenue from software and subscription and it is moving so rapidly in this direction that its marketing arm would soon have to develop a new way to describe the company. CEO Chuck Robbins has made it clear to customers, suppliers, employees and shareholders that he wants to turn the manufacturer of networking equipment into a provider of software solutions, joining a growing list of electronics and high-tech hardware manufacturer that are engineering similar moves in their enterprise operations.
“We've been rapidly shifting our model from a primarily hardware business to a software and services business and we will transition more of our revenues to a software and subscription based model and accelerate our shift across our portfolio,” Robbins said during a conference call to discuss the company’s latest fiscal results.
“We continue to add significant features and functionality to our security portfolio, both through internal innovation and M&A to meet our customers' most pressing needs, such as cloud defense orchestrator which provides cloud-based security policy management, stealth watch learning networks, which leverages a network infrastructure, analytics and distributed machine learning to provide visibility and security intelligence across the enterprise,” Robbins added.
Hardware OEM executives have long realized that their companies’ survival and continuing success depend in today’s market on how quickly they can bring out innovative products and update existing ones. However, it’s only beginning to sink in at some of these companies that there are inherent challenges in the hardware business that they may not be able to eliminate completely. One such problem is product commoditization, a scourge of the industry that was once associated primarily with suppliers of interconnects, passive and electromechanical (IP&E) components.
Commoditization and the severe pricing erosion that accompany it have since traveled deeper into the electronics supply chain. For decades, component suppliers have tried to resolve this problem by moving up the value chain through product innovation and the introduction of proprietary parts that competitors cannot easily or quickly copy. In the IP&E market, for example, companies like Vishay, Murata, Kemet and Epcos regularly roll out new products and various versions of existing components with the clear goal of staying above the commodity product baseline. Semiconductor companies, on the other hand, have also coupled this strategy with software embedded in their offerings. It is a race that keeps many IC industry CEOs and CIOs awake many nights a week.
OEMs, too, are beginning to hurt. The entrance of new, low-cost hardware vendors from China over the last decade has dramatically resulted in a loss of the leading positions companies like Cisco, Dell, HP, Ericsson and Alcatel-Lucent had in their market segments. As a result, these enterprises have been fighting off profit margin erosions with manufacturing outsourcing, job cuts, multi-year reorganization programs and forays into new markets.
Job Cuts Won’t Spark Growth
Those efforts haven’t always worked out, especially the job cuts, product streamlining and other reorganization activities. Despite efforts by companies to reduce costs and take advantage of outsourced production, hardware continues to lose out in a stiff race with software and subscription services. All across the high-tech sector, hardware manufacturers are infusing their equipment with software that they market as giving buyers the opportunity to lengthen the product lifecycle but which also offer OEMs the opportunity to cement relationships with customers.
Cisco, for example, has only recently announced the latest in a string of layoffs. It said in a press statement detailing its last results that it will cut 5,500 jobs or “approximately 7 percent of our global workforce.” While Cisco continues to face sales growth and margin pressures in its hardware business, the software and subscription segments have been surging at a double-digit clip, according to company executives.
By going for software-as-a-service (SaaS) as well as other subscription-related offerings, the traditional OEMs are drastically changing their revenue models. Hardware continues to be a major part of their product offerings but it is a less important segment due to the stiff margin pressures, high cost of innovation and growing uncertainty. OEMs have also realized that the lifecycle of hardware equipment can be fairly long especially at customers that strive to avoid recurring purchases. During such periods, the OEM is restricted to less lucrative repair and maintenance activities.
The software business is completely different. In addition to the opportunities for frequent upgrades and product optimization opportunities, a seller is likely to have a deeper insight into the customer’s operations, creating opportunities for incremental sales. And then there’s the regular payment for subscription services where the customer pays for the OEM to maintain, service and update the equipment.
This is an area Cisco is highly focused upon now, said Kelly Kramer, CFO of the company, during a recent conference call with analysts. Kramer said Cisco’s software and subscription services represented 28 percent of company revenue in the last fiscal year, up from 25 percent in the prior fiscal year.
“It’s part of why we're driving our shift to software. Those [software and subscription] businesses have great margins,” Kramer said. “In terms of when do we change our model or our guidance, I think that will come over time as we make bigger shifts at the company level. But that is our goal as we shift to more software that have those nice, great margins.”
From Ink Cartridge to Breakups and Now to Software
Hewlett-Packard had a different strategy before Meg Whitman came along as CEO. Under the last two CEOs, the company placed a huge bet on growth continuing in its printer business where it was generating huge margins from the sale of ink cartridges. In fact, former CEO Carly Fiorina was so gung ho about the future of the PC hardware business that she shelled out a bundle for Compaq, a fiasco in hindsight.
What’s left today of the former HP couldn’t be any different. This week, Whitman announced the spin-off of Hewlett Packard Enterprise’s software assets and its merger with Micro-Focus. The transaction continued Whitman’s vision of turning the rump of the old HP into an enterprise described as a provider of “software-defined infrastructure that will run customers’ data centers today, bridge them to multi-cloud environments tomorrow, and enable the emerging intelligent edge that will power campus, branch and IoT applications for decades to come.”
Prior to the Micro-Focus transaction, Whitman last year broke the old HP into two, splitting off the PC and printer unit as HP Inc. That unit continues to struggle with fiscal 2016 third quarter sales dropping 4 percent from the prior year. “The market remains very challenging,” said Dion Weisler, president and CEO of HP Inc., during a conference call. “We were more challenged in our business ink products where we drove pricing discipline and lost some share.”
At Hewlett Packard Enterprise, Whitman has been swift to tamp down on any speculations that the company might be getting out of the software business. In fact, the company is moving in the opposite direction, she said, despite the decision to offload some software business to Micro Focus. The company is doubling down on “delivering software-defined hybrid IT,” Whitman said.
“I want to be crystal clear – HPE is not getting out of software,” Whitman said in a statement. "Software is still a key enabler of our go-forward strategy, but we need the right assets to win in our target markets. Moving forward, we will double down on the software capabilities that power and differentiate our infrastructure solutions and are critical in a cloud environment."