Satya Swallows the Fish

By Tien Tzuo November 29, 2019

Satya Nadella was recently named Fortune’s Businessperson of the Year. It’s well deserved. I’m old enough to remember Microsoft as being sort of like the Star Wars franchise. It started off great, then had a really rough middle patch, and now it’s back on track in a big way.

But Microsoft’s resurgence obviously didn’t just come out of nowhere. Roughly five years ago, Satya Nadella made some very smart (but also very unpopular!) decisions and investments that set Microsoft up for success in a cloud-based world. In shifting his company away from static hardware and on-premise sales towards a subscription-based cloud model, Satya Nadella swallowed the fish.

Let me explain what I mean by that.

In their excellent book “Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business,” Thomas Lah and J. B. Wood refer to the transition period from on-premise to SaaS as “swallowing the fish,” as the revenue curve temporarily dips below the operating expense curve before climbing back upward again.

The fish is what happens when a traditional company starts to shift its revenue mix from an asset purchase model to a subscription model. During this period, the company experiences a string of quarters where top-line revenues shrink as revenues from large, pay-up-front deals are replaced by recurring subscriptions without the big up-front payment. This has happened to lots of big enterprises like Adobe, PTC and Cisco.

At the same time as revenues dip, the company must make investments in many of the new capabilities and structures that are required for a profitable subscription-based model. The traditionally profitable and stable mix of more revenue than costs on the left side of the chart is replaced with a tumultuous period of costs exceeding revenue.

The end result, however, is that this period of investment and restructuring results in greater efficiencies and higher higher revenue growth, thus completing the fish curve:

And as Lah and Wood note in their book, lots of management teams chasing after quarterly numbers generally don’t like the look of that fish! They would just as soon avoid it altogether. There are boards and investors to consider, not to mention the press and analysts, who are working on hourly news cycles.

But doing nothing is a trap, particularly in a competitive market. Large companies frequently wind up as successful mediocrities, propping up temporarily profitable revenue models that are ultimately doomed. As J.B. Wood notes in his book: “Profitable, incumbent players seem to stand still as new entrants disrupt a marketplace. They are reticent to disrupt their profitable economic engine—even as customers start to leave and revenues start to shrink.”

I don’t think that this is the exact dynamic that happened to Microsoft (there were a lot more factors involved than a straightforward on-premise to SaaS shift), but in five years they definitely made some strategic decisions that entailed higher short-term expenses in order to establish a trajectory of long-term growth. Let’s take a look at Microsoft’s stock chart:

Notice that there’s a mixed period from mid-2014 to mid-2016, where after making some incremental gains the stock appears to stall out for a couple of years, before starting a steady ascent upwards:

What’s going on here? Well, if we take a look at that same time period through the lens of trailing 12-month expenses and revenue, we can find our fish:

Source: Macrotrends

The expenses represent the top side of the fish. See the bump? While there could be a number of reasons for this uptick, I would bet that Satya Nadella was spending a lot of money and R&D on building out his server infrastructure and service-oriented field team during this time. Microsoft knew that it had to make some investments in order to pivot to the cloud. Satya was getting out of tablets and phones, and investing in data centers and services.

Source: Macrotrends

And trailing revenue, which represents the belly of the fish, dips during this time period as Microsoft shifts its revenue mix from products to services. But that’s all part of the plan. Starting in mid-2016, the revenue (and the stock price) begin their long ascent upwards. In short, I think this time period represents a very deliberate corporate pivot.

Successful enterprises don’t just get lucky. They invest in order to put themselves in a position to take advantage of long-term market trends, and they frequently do so at the cost of short-term gains and market reactions. This is what McKinsey calls building a roadmap for digital transformation.

Of course, this model doesn’t only apply to software or technology companies. Whether you’re an auto manufacturer or a consumer packaged goods company, a big part of your future growth is going to come from digital subscription models, which require some short-term investment and restructuring. In the context of the broad global shift from products to services, this is a play that applies to everyone. Microsoft offers a blueprint for all of us.

Satya Nadella swallowed the fish.

 

For more insights from Zuora CEO Tien Tzuo, sign up to receive the Subscribed Weekly here. The opinions expressed in the Subscribed Weekly are his own, not those of the company. The companies mentioned in this newsletter are not necessarily Zuora customers.

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