The State of Product-Centric Partners in 2016

What's Actually Happening in the VAR/Reseller Business Model Based on Empirical Data

In last month's whitepaper – "No, the Cloud Isn't Putting Thousands of Partners Out of Business" – we debunked the current claim of some well-known industry analysts that the advent of Cloud will put "30% of partners out of business."

We also said that in this month's whitepaper we would provide an exclusive Product-Centric excerpt from the soon-to-be-released Service Leadership Index® 2016 Annual Solution Provider Industry Profitability Report©.

Readers of this whitepaper are the first to see this latest data.

Product-Centric is Not a Four-Letter Word

The Service Leadership Index objectively categorizes all Solution Providers (globally and across all sizes and segments) based on their revenue mix, into one of 10 Predominant Business Models© (PBMs):

  • Product-Centric;
  • Five distinct infrastructure-services-centric business models; and,
  • Four distinct applications-services-centric business models.

This is because each of the 10 PBMs responds to different best practices and has different financial performance potential (more on this, here). Each also has different stock value.

Product-Centric firms are those with at least 60% of their top line revenue (not gross profit) coming from reselling hardware and software. This PBM responds best to "services-led" rather than services-centric best practices.

(Firms with more than 40% of their revenue coming from their own services, are categorized as services-centric. Then, whichever line of services is at least 10% greater in revenue than the others, is designated the predominant line of business, and the appropriate best practices and performance targets are applied.)

It's important to note that a Product-Centric firm in the top quartile of profitability for its PBM, handily delivers a higher bottom line profit percentage than do any services-centric firms who are performing at median for their PBM.

This is shown in the chart below, which compares the top quartile profitability (Best-in-Class or "BIC") and median profitability firms in various PBMs over the past 32 quarters.

EBITDA Results by PBM

As you can see, over the past eight years, one-quarter of Product-Centric firms (the Best-in-class or "BIC") had bottom-line profitability of 12.2%, after the owners take fair market compensation for the job they hold in the company from the income statement.

In contrast, service-centric firms at median profit performance for their PBM, do not exceed 7.6% bottom line after owner fair market income. Size for size, the BIC Product-Centric firms deliver at least 60% more profit dollars to their shareholders than do the median service-centric firms.

This difference is even more material given that the average Product-Centric firm has about five times the revenue of the average service-centric firm. This means, in round numbers, the average-sized Product-Centric firm, if it runs at BIC profitability for its PBM, delivers something like 300% more profit dollars to its shareholders, then does the average-sized services-centric firm running at median profitability for its PBM.

Stock values of privately-held Solution Providers are typically based at least partially on EBITDA dollar production, which puts the Best-in-Class-performing Product-Centric firms in a good light. That said, business model – services revenue and especially recurring services revenue – also typically plays a large role in valuation.

We'll address optimal valuations in more depth in next month's white paper, but suffice to say that those Product-Centric firms who have the highest stock value, have done so by successfully becoming "service-led" yet – purposefully – not becoming fully services-centric.

For now, let's continue to dig into the latest Service Leadership Index results.

Profitability Continues to Trend Down for Product-Centric Solution Providers

Unfortunately, 2015 was the fourth successive year of profit decline for Product-Centric Solution Providers. As the chart below shows, the top quartile in this business model in 2015, attained 10.1% EBITDA after fair market owner compensation.

EBITDA % by Year - PBM: Product-Centric

Although this drop is slightly decelerated from those of the previous three years, it is still material – in absolute terms, the 0.5%-point decline represents a nearly 5% drop in EBITDA dollars from year-to-year if the firm remained the same size (which as we shall see, thankfully, the average firm did not).

To be fair, the high profitability results of the median and BIC in 2009 reflect those Product-Centric firms during the year or two following every recession. They pare back costs diligently in the first recession year; the BIC firms pare ruthlessly, the median firms less so and the Bottom ¼ firms little or not at all. As a result, in the year or two after the recession, when revenue starts to rise, profitability soars.

(The management teams of the BIC firms have the greatest ability to defy broader economic trends. Those of the Bottom ¼ have the least ability to buck the down-trends, and their results most closely mirror the broader economy.)

Looking at the 2012 through 2015 results, however, it's clear that profit pressures on Product-Centric firms are impacting all three performance quartiles, and that the trend started before Cloud became a household word. It's also important to note that, in 2012, 2013 and 2014 (as we'll see later in this white paper) the bottom line profit dollars generated by Product-Centric firms increased even as the profit percentage decreased, because of large increases in sales volume.

Let's dig into what is causing this downward profit percentage trend, and see how the Best-in-Class (those in the top quartile EBITDA % for the PBM) nevertheless optimize their results.

P&L Ratios by Profit Quartile

Among other things, the top quartile Product-Centric firms are more effective at producing gross margin dollars from each dollar they invest in sales and marketing. As the inset shows, the Best-in-Class get $4.46 of gross profit from each sales and marketing dollar, about 35% more productivity than the median firms and nearly double that of the bottom ¼ firms.1

One might incorrectly suggest that, although all Product-Centric firms have at least 60% of their revenue coming from resale, perhaps those in the top quartile of profitability have more services revenue than do those in the bottom quartile. In fact, that is materially incorrect: in 2015 those in the bottom quartile of profitability had 24.1% of revenue from services, while the median Product-Centric firms had 22.9% and the top quartile had 26.2% of their revenue from services. In short, there is no meaningful difference in the top performers' proportion of revenue made up of service.

It is how service, and product, are being sold and delivered, that separates the Product-Centric companies who are successfully services-led versus those who are not yet. For example, here are just three of the behavioral differences exhibited by the top performers:

  • Our footnote description of how to correctly categorize pre-sale engineering and unbilled labor hours isn't just what the top performers do to benefit transparency. They do it because it also produces behavior changes in strategy, sales and service which favor greater services "attach," lower services Cost of Goods (COGs), higher service delivery quality and accelerated sales cycle, all of which benefit higher product revenue growth at higher margins.
  • Seemingly paradoxically, top performers narrow the range of products for which they commit to providing implementation, support and Managed Services, which drives up margin, quality, customer value and revenue growth.
  • Top performers pay sales people on actual services gross margin, not on imputed or guaranteed services margin, recognizing that while Service is indeed responsible for as-delivered margins, Sales has a material influence on it as well, both before and after the sale.

As a result of these and roughly two dozen other key best practices evidenced by the top performing (that is, successfully services-led) Product-Centric firms, their ability to drive added value to their clients while operating more efficiently, enables them to earn higher gross margins in most practices and on product resale.

Selling essentially the same mainstream products to the same mainstream customer verticals and sizes, the Best-in-Class Product-Centric firms earn notably higher product resale gross margins:

  • Product GM% of Product-Centric in Top Quartile of EBITDA% in 2015: 20.2%
  • Of those at Median EBITDA%: 16.9%
  • Of those in the Bottom Quartile of EBITDA%: 17.3%

On an absolute basis, the top quartile Product-Centric firms earn nearly 17% more gross margin dollars on each dollar of product resale revenue than do the bottom quartile (20.2% ÷ 17.3%). This is primarily a result of their better use of two sales levers:

  • A higher level of relationship with the customer afforded by a successful services-led strategy; and,
  • An increased dependence of the customer on the partner because of the more critical nature of the systems and services needed (higher operating consequences to the customer, and greater visibility of them to customer senior management).

Together, these factors give the partner the leverage to avoid needing to be the lowest product bidder on more deals, and even to be one of the high bidders on many.

Their successful services-led strategy both enables and is enabled by higher value, more differentiated services – albeit mainstream services focused on the same mainstream products – which the customer finds they cannot reasonably do without.

Ironically, the successful service-led firms don't offer different services than less-successful firms, they deliver them with greater quality, that is, greater assurance to the customer of being on time, on budget and on specification. Implemented in the relationship in the most holistic sense, this accounts for much the hold the top-performing firms have on margin and market.

The pivot of the top quartile Product-Centric firms to services-led is a result of their successful adoption of the three behaviors described, and of the roughly two dozen others alluded to2, on the preceding page. Enacted together, these enable the partner to drive greater value to the customer while increasing Service operating efficiencies and quality (as well as efficiencies in Sales and G&A operations in relation to services).

The result in terms of higher service prices won and lower services COGs per dollar of service revenue, are shown in the chart below.

Gross Margin % by Service LOB

Keeping in mind that Professional and Managed Services represent the lion's share of Product-Centric firms' services revenue, the chart shows that those firms in the top quartile of EBITDA%, earn materially higher GM% on those services.

When the GM% of the four Infrastructure practices is measured in aggregate (second set of columns from the right), it is more than seven points higher in top quartile EBITDA% firms than the median firms, and 15 points higher than the bottom quartile firms.

In practice, the top quartile gets $2.10 of services revenue for every dollar of taxable service wage, while those in the bottom quartile get only $1.50. The top quartile gets 40% more margin dollars in absolute terms.

(The GM% of the applications services practices of Product-Centric firms is immaterial because of the small share of total revenue won by these services.)

Combined with the higher product margins, this results of course in higher overall (blended) GM%, which better offsets sales, marketing and G&A costs. In 2015:

  • The top quartile EBITDA% Product-Centric firms spent about 65.7% of their GM dollars on Sales, General and Administration ("SG&A"),
  • The median EBITDA% firms spent 87.6% of GM on SG&A, and
  • Unfortunately, the bottom quartile EBITDA% firms spent 132.7% of their GM dollars on SG&A (that is, they made a loss).

Thankfully, there are top quartile performing firms in every market, pursuing every customer segment, representing every vendor.

When it comes to financial performance, the impact of the successful techniques of those Product-Centric firms at high Operational Maturity Level© greatly outweigh the influence of geographic or market factors.

Those at low Operational Maturity Level are more impacted by local and market factors, but their primary challenges come from grappling less successfully with the bigger levers discussed here.

Revenue Growth Slowed but Expense Spending Did Not

In 2015, the average Product-Centric firm saw its revenue grow, but at a much slower pace than the previous three years, as shown in the chart below:

Y/Y Growth in Total Revenue

If we drill down into the most recent eight quarters, we can see much of this deceleration took place in Q1-2015 (though it started in the last quarter of 2014), with a gradual recovery accelerating in each subsequent quarter of the year.

Q/Q Growth in Total Revenue

With all four quarters of 2014 showing increasing revenue (despite relatively anemic growth the fourth quarter), revenue in 2014 was a robust 23.9% higher than in 2013 – a good growth year indeed.

In contrast, then, the meek 3.4% growth in 2015 over 2014 felt to most Product-Centric partners like trouble. And, indeed, with SG&A investment running at higher levels to keep up with previously fast growth, it outstripped growth in GM dollar production, with predictable results at the bottom line.

Y/Y Change in GM$ and SG&A$

The chart shows that in 2012, 2013 and 2014, Product-Centric firms grew their pile of incoming GM dollars (blue columns) faster than they grew the pile of outgoing SG&A dollars (red).

In 2015, however, although Product-Centric firms did grow their pile of GM dollars by 3.2%, they continued to add to their pile of SG&A dollars at about the rate they had been for the past two years when GM dollar growth was much higher.

This overrun in expense spending is most common in the Product-Centric business model as compared to the other nine Predominant Business Models, which are all services-centric. This is due to two factors:

  • First, product resale revenue has a shorter forecast horizon than any of the services revenue streams.
  • Second, although failing to attain budgeted revenue and GM dollar goals is painful for Product-Centric firms, it is more so for service-centric ones (because their service COGS continues even if the sale isn't made).

Thus service-centric firms are on average more diligent about becoming better forecasters, and about responding more quickly to forecasted and actual downturns in GM dollar production by reducing spending of all kinds.

This, then, is the reason for the decline in profitability of the Product-Centric firms, not any impact of the Cloud:

  • Product-Centric firms simply kept growing SG&A dollars at the rate they had for the previous two years, but GM dollar production didn't grow as it had.

The effects of both levers (GM$ and SG&A$) moving the wrong direction in relation to each other, always has dramatic impact on the bottom line, as the chart below shows:

Y/Y Change in EBITDA$ and ADj. EBITDA$

While the Product-Centric firms' pile of EBITDA dollars (whether adjusted or not for owners' fair market compensation), grew substantially in 2012, 2013 and again in 2014, it shrank materially in 2015, even as revenue and GM dollars grew slightly.

Sometimes the oldest rules are the best: grow SG&A spending at half the rate of GM$ growth, and you'll be happy. For Product-Centric firms especially, this means getting more operationally mature at budgeting and forecasting.

Revenue Mix of Product-Centric Firms is Slowly Changing

One might be tempted to argue that the decline in revenue growth (and in accompanying GM dollar growth) was caused by the customers shifting their spending away from capital equipment and towards operating expense (Cloud).

As we saw in last month's white paper, while Cloud revenue is growing rapidly percentage-wise, it is still a small fraction of overall IT revenue among vendors and partners, and of overall spend by customers. In short, it's new and tiny, so growth will look strong in percentage terms. Yet more empirical evidence echoes our analysis in last month's white paper.

The chart below shows the revenue mix of Product-Centric Solution Providers in 2011 and 2015. The proportion coming from "non-recurring product hardware/software (HW/SW)", that is, traditional product resale, has remained the same – essentially 80% of total revenue.

Revenue Mix by Line of Business

Thankfully, the proportion of revenue from applications services (orange segments) was small in 2011 and declined further by 2015.

Product-Centric and infrastructure-services-centric firms occasionally attempt to be in the applications services business (much more often than applications-services firms try to be in the infrastructure or product resale business), but a high proportion of them lose money at it and fail to create happy customers and happy sales people. High-performing Product-Centric firms tend to stay away from applications services.

The proportion of Product-Centric firms' revenue from infrastructure services (green segments) has crept up from 14.8% of revenue to 15.3%; not stellar growth, but progress nonetheless. Gross margin dollar production from infrastructure services has likewise crept up from 27.9% of GM dollars in 2011 to 30.6% of GM dollars in 2015 (chart below).

Share of GM$ Production by Line of Business

Gross Margin dollar contribution from commissions and agency fees (black segments in the chart immediately above) declined in 2015 from the go-go product sales years of 2013 and 2014, as would be expected. However, also in this bucket would be the commission dollars received for reselling Cloud services; if Cloud commissions did increase year-to-year, it must be masking a large drop in other commissions and agency fees.

It's unlikely a large drop occurred, though, because the GM$ dollar contribution from commissions and agency fees has merely returned to the more normal levels of 2011 and 2012 (when Cloud was negligible).

In 2015, the biggest upward mover in GM dollar production in absolute terms was product resale. This is not the effect you would expect to see if Cloud were materially cannibalizing that revenue stream.

Within the Product-Centric firms, what is the speed of change of revenue mix? The table below shows this in some detail.

Cloud resale did indeed grow in absolute dollar terms as well as share of revenue mix, from 2011 to 2015: 75.0% Compound Annual Growth Rate (CAGR) in revenue and 45.8% CAGR in share of revenue. That said, it was only 0.3% of the average Product-Centric firm's revenue in 2015. One would think that if third-party Cloud were a major investment by end customers, a typical Product-Centric partner, no matter how inept, would garner at least some material share of that.

Likewise, private Cloud – that is, cloud capacity built and owned by the partner for their direct sale to the end customer – while growing quickly, was also small: only 0.6% of the average Product-Centric partner's revenue in 2015. Again, one would think that any large-scale end customer movement to the Cloud would at least partially accrue to Product-Centric partners.

In both cases, the small share of revenue coming from either type of Cloud, indicates that the Cloud business is, at least through 2015, more smoke than fire.

Conclusions and Recommendations

We mentioned earlier that the Service Leadership Index tracks all 10 partner Predominant Business Models. Cloud revenue share and growth rates for all of them are similar to the low levels the Product-Centric are experiencing.

Even those who are Cloud-centric – including ones famously tagged as "born in the cloud" – represent a small share of overall IT spend. In our soon-to-be released Annual Solution Provider Industry Profitability Report©, we'll provide a deeper dive into the latest Cloud business data to give you the most actionable advice.

Meanwhile, suffice to say this. Cloud has enormous media exposure, as perhaps it should. Certainly the IT manufacturers spend large sums to create interest around any "new computing paradigm" to drive sales, and often like to dally with going around the channel. Cloud implies the possibility of both of these.

The empirical data, however, doesn't yet support the claim that Cloud is taking over. Instead:

  • The simplest answer to the question of what caused 2015 to be a slower year for Product-Centric partners – though still a growing one – is that end customers increased their traditional IT spending with partners dramatically in the three preceding years: almost 9%, 19% and 24% in 2012, 2013 and 2014 respectively. After investing heavily, they pause.
  • The simplest answer to the question of what caused Product-Centric partners to be lower in profitability in 2015 is that, true to their usual pattern, they continued growing SG&A spending at their 2012-14 pace in the face of a slowdown (but not a reversal) of GM$ growth.

Is Cloud decimating the channel? No, not based on the data. Will it? Only if Solution Provider owners and executives fail this time to exhibit the entrepreneurial drive and accomplishment that they exhibited each of the last dozen or so times the analysts claimed that transformational changes were going to obsolete masses of partners.

Recommendations:

  • Do top performing Product-Centric (and other business model) partners promote Cloud to the customers? Yes, with great energy and diligence, because it brings prospects in the door.
  • Do these top performing partners sell Cloud? Yes, they incorporate judicious Cloud solutions into a self-branded and heavily self-marketed "customer-optimized architecture" which allows them to efficiently focus their sales and service resources while differentiating themselves in the market.
  • This is merely what top-performing partners have always done: chosen from the best available technology – new school or old – to bring their customers the best value, and thereby earn the best value creation for themselves.
  • Is the transformation to services-led and then to best-in-class results, easy or simple? No, but the path is charted and proven.
  • Product-Centric executives often ask us, "What proportion of Product-Centric firms successfully become services-led and then attain best-in-class value creation?" In our experience, the practical answer is: "All who keep trying."

If you need help understanding how to identify and incorporate the best practices that will move you along the path to Best-in-Class performance, Contact us to learn more about the tools and services available.

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