Software Assurance Storm Warning

In a report to be published today, Forrester Research sees a series of customer hurricanes coming Microsoft's way. If they strike, they could wash away many Software Assurance contracts. Software Assurance is the discounted upgrade option available with Open, Open Value and Select volume licensing contracts.

Forrester surveyed IT procurement professionals from companies with 3,000 or more employees. Eighty-six percent said that their Software Assurance contract would expire in 2007. If these 46 IT professionals are indicative, Microsoft has a lot of money on the line, and for some time ahead as the contracts typically are two-to-three years long.

Problem for Microsoft: Fifty-seven percent of IT procurement professionals told Forrester that they either won't renew their Software Assurance contracts or are undecided. By contrast, less than 25 percent said they would definitely or would likely renew their contracts.

Among the 26 percent of businesses that definitely won't be renewing Software Assurance, 74 percent said that the economics don't make sense. More troublesome for Microsoft, 54 percent of the same IT procurement professionals said they already have rights to the latest products, while 59 percent weren't convinced Microsoft would release upgrades during the contract period.

Julie Giera, a Forrester Research vice president, said that she has interviewed 400 companies since January and that "80 percent had complaints about Software Assurance pricing."

Those companies with rights to upgrades could be an even bigger problem for Microsoft. Enterprises with upgrade protection in place in November would be eligible for new Exchange Server 2007, Office 2007 and Vista licenses. They could get the upgrades even if choosing to let Software Assurance contracts lapse. Somewhat by intention and somewhat by fault (because of shipping delays), Microsoft lined up a bunch of new products just before many customers' contract expirations. With rights to the newest stuff in hand and new version upgrades years off, many enterprises are in position to skip this Software Assurance renewal cycle.

"The timing is interesting for Microsoft," Giera said. "Customers that have Software Assurance in place in November have rights [to the newest upgrades]. Many of them are saying they'll just buy in later."

The problem could be wider spread than Software Assurance. Upgrade protection is built into Enterprise Agreement, which may hit a renewal crunch, too.

"It seems to me that the planets are lining up for a harder than usual EA renewal cycle," said Paul DeGroot, lead desktop strategies analyst for Directions on Microsoft. "Some customers whose EAs expired last year may have renewed for one year, which you can do once. That got them to Vista and Office 2007. That was my advice to some of our clients who were asking about this last year: renew for a year, then reassess the situation."

Forrester's report comes on the eve of Microsoft's annual partner conference. The company said it couldn't provide a response to Software Assurance renewal questions, because of preparations for the event.

Checkered Past Marks the Future
Microsoft introduced Software Assurance as part of Licensing 6 in May 2001. The plan received scathing response from analysts and customers. Under Microsoft's Licensing 5, companies had the option of buying upgrades when they wanted and paying a discounted price at time of acquisition. Licensing 6 did away with off-the-shelf upgrades and, through Software Assurance, had companies paying upfront for software, under two- or three-year commitments. For upgrade rights, customers pay 29 percent annually for desktop products and 25 percent for server software. In 2001, Gartner estimated that about 80 percent of Microsoft customers would see price increases ranging from about 35 percent to 107 percent.

Licensing 6 and Software Assurance were so unpopular, Microsoft delayed the switchover until summer 2002.

While customers cringed, Microsoft hugely benefitted. The upfront upgrade payments helped smooth out Microsoft financials—lessening the revenue highs and lows between major product upgrades—and insulated the company from soft technology spending in 2002 and 2003.

Because upgrades are delivered over a multi-year basis, Microsoft realizes revenue on an ongoing basis rather than as it receives customer payments. Revenue is deferred and appears on Microsoft's balance sheet as unearned revenue. Most of Microsoft unearned revenue comes from volume licensing, but not all. Microsoft defers revenue for other reasons.

Unearned revenue has made a huge contribution to Microsoft's bottom line. In most quarters, more than 25 percent of actual revenue is recognized from unearned revenue. The company estimates about 40 percent of revenue comes from volume licensing—more from server software and desktop applications and much less from Windows. About 80 percent—or more, depending on the quarter—of client operating system revenue comes from OEM sales. Windows is the exception.

Any major reduction in license renewals would have huge consequences to Microsoft's bottom line, because of unearned revenue's role. Signs of any problems, if there are any, should show up next week, when Microsoft announces its fiscal 2007 fourth quarter and year-end results. However, because Microsoft recognizes licensing revenue over time, the material impact—if there is any—would be several quarters or more away.

"The impact is a three-year impact; it's not just this year," Giera said. "It's pointing to a larger impact of recurring revenue over the next couple of years."

Fundamental Disconnection with Enterprise Priorities
Software Assurance offers limited assurance to companies signing up for it. Microsoft makes no guarantee that it will deliver new product versions during the contract period. Product delays hit Software Assurance subscribers hard if they pay with the expectation Microsoft will deliver a new version.

Even in the best-case scenario—Microsoft delivering next-generation products on time—the math works against some Software Assurance renewals.

Assuming next versions of Office and Vista "arrive on schedule in late 2009 or early 2010, you'll take a year to evaluate them and develop your desktop configuration," DeGroot said. "So now it's 2011. Since that may be even an optimistic scenario, why would I pay Microsoft for three years of updates between 2007 and 2010?"

The break-even point for Software Assurance is three-and-a-half years, according to analysts and Microsoft. Companies that upgrade beyond four years would save more money by paying full price for software.

Microsoft is promising minor and major upgrades, on two- and four-year cycles, respectively, for products like Office and Windows. But Giera said the version strategy is no assurance. Given that many businesses need 18 months to test and begin early deployments, the two-year cycles are too frequent. But four years is too long for Microsoft, because businesses would no longer have incentive to buy upgrade protection. Full price would be cheaper. Then there is the increasing enterprise practice of stretching upgrades out even further than four years.

In that sense, "this isn't a three-year problem but a five-year problem for Microsoft," Giera said.

Another problem—and one Forrester sees creating some long-term customer-relationship problems—is Microsoft's approach to Enterprise CALs (client access licenses). Microsoft introduced new, Enterprise CAL suites with the 2007 release cycle. Customers that bought into Software Assurance in the past are finding that they now need to buy additional and unexpected CALs to use some Exchange Server 2007 and SharePoint Server 2007 features. Microsoft also introduced new Office server CALs.

"Some customers feel betrayed by the Enterprise CALs," Giera said.

If Forrester has the pulse of enterprises, it's not beating in time with Software Assurance renewals.

DeGroot sees another mitigating factor that could give businesses, particularly those with upgrade rights to Office and some server software, another reason to pass up this renewal cycle: Competitive alternatives. In the four years since the last major bulk of contract renewals, Linux and other open-source software such as OpenOffice have made huge enterprise strides.

"They are undergoing continuous, regular improvement, not going dark for years [like Office or Windows]," DeGroot said. "If that pace of improvement keeps up over the next three to four years, they could be taken seriously. So maybe you want to leave your options open. Get off the Microsoft train now, when the strategic cost is low—since you've got a major upgrade in the bag already with your current entitlements—and give yourself a breather, as well as time to pilot some alternatives."

Related Posts:

• Say It Ain't So, Microsoft Watch, July 6, 2007
• TechEd: Vista Logos, Server Tools, Microsoft Watch, June 5, 2007
• Volume Licensing: It's a Buyer's Market, Microsoft Watch, April 10, 2007
• Convergence=Integration, Microsoft Watch, March 12, 2007
• Software Reassurance, Microsoft Watch, February 19, 2007