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The 5 Pillars of Digital Transformation for Software Companies

How we expect spending at Zoom, Microsoft, Slack, and more to evolve in a post-COVID-19 world.

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The coronavirus brought about an explosion of remote-work software adoption, as companies acquired the necessary tools to continue normal operations. Collaboration and workflow solutions like Zoom (ZM), Microsoft Teams (MSFT), Slack (now owned by Salesforce.com (CRM)), and DocuSign (DOCU) thrived financially amid this booming demand.

We posit that the next several years are likely to see growth of the expanded set of technology tools that enable remote work, as hybrid work environments increasingly become the norm. Within our coverage, we think that the strong will get stronger and that the biggest beneficiaries thus far will remain the biggest winners over the next couple of years.

As we look ahead, not only are we optimistic about ongoing remote-working software usage, but we also foresee the move to remote work as accelerating digital transformation. We ultimately see spending on digital transformation growing at a 16% compound annual growth rate from 2020 to 2025, resulting in a $1.8 trillion opportunity in five years.

Each leading technology company characterizes digital transformation differently, but we define it as simply using software to modernize business processes. We believe the critical concept is that it involves both a technology element and a business process, or operational element.

6 Ways Software Spending Will Evolve to Accelerate Digital Transformation

We think the next several years will be exciting for software providers and their investors, as software spending is changing along several different vectors and will benefit from this evolution. Digital transformation was a favorable secular trend for the software industry, but COVID-19 has accelerated this trend in the near term and perhaps the medium term as well.

We expect digital-transformation-related spending to evolve over the next several years in six main ways:

  1. Because modernization and digital-transformation efforts continue and have even accelerated, demand will be pulled forward by perhaps two years.
  2. IT budgets, which are generally stable, will see an overall uptick in 2021, even if IT spending growth typically remains consistent over longer periods of time.
  3. Software expenditure will grow in the mix of IT budgets. This trend is not necessarily new, but we expect the uplift to continue over the next five years. We also expect software to outgrow gross domestic product by a considerable margin over time because it solves critical business problems, allows for higher revenue generation, and results in high returns on investment.
  4. In some instances, software spending will be pushed to functional corporate areas, which could obfuscate true IT spending. We think this point helps alleviate pressure on IT budgets that might arise in our second and third points above. A business segment could then use a preferred software platform and absorb the costs for it as well. In this case, the extra spending likely rolls up into cost of goods sold for that segment. In other words, not all IT spending is included in the IT budget.
  5. The explosion in remote-work enablers will evolve into the retention and expansion of those solutions to customers who have implemented them. For example, we have already seen good follow-through on customers acquired by Zoom and DocuSign during the depths of the coronavirus-driven lockdowns.
  6. Because it immediately laid bare the issues with legacy systems, the COVID-19 pandemic will ultimately drive acceleration of digital-transformation efforts.

This digital transformation will touch on five main pillars, outlined below.

Cloud

The use of a public cloud allows a company to reduce or redeploy IT head count while generally moving the infrastructure to more-advanced technology building blocks. This decision then lowers IT costs directly through lower up-front capital expenditures on hardware and lower ongoing maintenance requirements, which then allow for lower IT head count or personnel redeployments. It also results in improved IT performance on many facets, the most important being increased flexibility, faster performance and throughput, and better security.

Amazon.com's (AMZN) Amazon Web Services is widely perceived as the leader in public cloud. We see Microsoft's Azure as the only other legitimate competitor, with Alphabet's (GOOGL) Google Cloud Platform a distant third. However, we do think it's possible that over time Google or another competitor will improve its capabilities and expand its footprint to have a truly viable competitive position. We also think the market is enormous and can accommodate three large competitors and perhaps even a couple of smaller competitors.

Workflow and Automation

A great variety of widely used software platforms contain a no-code or low-code feature for creating rules to automate basic and repetitive tasks--and automation helps users work more efficiently, thereby allowing enterprise customers to "do more with less." This can be seen as worker efficiency improvements or cost savings--depending on if the company is redeploying head count elsewhere or hiring less--strict cost savings, or simply increased flexibility, which we tend to view as a driving force in contemporary strategic IT decisions.

We offer Salesforce as leading the charge with its initial salesforce automation, or SFA, solution. SFA advanced customer-relationship-management software to a new level with new features and automation of repetitive tasks, thereby freeing up users to focus on their priorities: selling and generating revenue.

Customer Experience

Customer experience has been well defined with some obvious important competitors, such as Salesforce; it is also rapidly evolving as new tools have emerged, and it helps retain existing revenue streams as well as promote upselling into the installed base. We remind investors that it is significantly cheaper for a software vendor to retain a customer than it is to gather a new customer, which explains the special focus on customer experience.

There is also a modernization element to customer experience, which we view as driven by the need to meet customers where they are. In consumer-facing businesses, this is increasingly online and mobile, and includes not only basic e-commerce, but also customer service by whatever means the customer chooses, be it text message, voice call, Facebook, or chatbot.

We see customer relationship management, marketing, e-commerce, and customer service as organically synergistic and basically extensions of one another, so we combine all of them in our discussion. That said, we expect customer experience software to generate more than $100 billion in annual revenue in a few years.

Artificial Intelligence and Analytics

Data has become the lifeblood of the modern enterprise, with decisions increasingly based on measured information on an expanding set of key performance indicators. Using more sophisticated tools, companies are better equipped to answer questions about their operations and customers. Artificial intelligence, or AI, and analytics tools can be used to help make predictive decisions about what products to show consumers on e-commerce sites, as well as recommend solutions to customer-service situations.

They are not just for powerful platforms. Most companies in our coverage--ranging from large cap to small cap--have some type of AI, machine learning, or analytics available for their users. We think that AI and analytics can be incorporated in other areas, such as automation, SaaS modernization, or even cloud.

Based on our estimates, the AI and analytics software market was approximately $50 billion in 2020, and we expect it to increase to more than $150 billion by 2025. 

SaaS Modernization

Software buyers don't just want software-as-a-service delivery: They also want the underlying modernization impact, which ranges from more-intuitive user interfaces, a clean and simplified source code, and better use of application program interfaces, or APIs. On this last point, we stress that we have long heard of software buyers' desire for flexibility and to avoid vendor lock-in. APIs allow applications to interface smoothly and draw on functionality from other vendors. Today, we see software vendors using APIs extensively to deliver flexibility to customers, which ultimately creates better relationships and improves customer retention.

SaaS surged from a 0% share of software delivery in 1999 to a 22% share of the market in 2020--and we see no scenario where SaaS does not stay on this trajectory to eventually become the vast majority of software. As popular as SaaS is, we believe users and providers will continue to consolidate around SaaS delivery until it is nearly all software in use, which may take a couple of decades.

Dan Romanoff does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.