Generative AI eats SaaS

The current economic model SaaS firms use to generate revenue and shareholder value is being upended as enterprises signal a fundamental shift in how they’ll buy software in the future. On Thursday, May 30, 2024, Salesforce shares tanked by 20% a day after the company released weaker-than-expected earnings for its fiscal 2025 first quarter. This filing led to the company’s worst trading day since July 21, 2004. The SaaS vendor said revenue for the period increased 11% to $9.13 billion, but shy of the $9.17 billion expected by Wall Street analysts. CIOs (and CEOs) must take note of this as the inflection point of change.

While many financial analysts claim this is due to economic headwinds leading to an enterprise IT spending slowdown and that generative AI projects are gobbling up more spending than expected, HFS believes the deeper issue is enterprises’ increasing focus on generative AI becoming the leading application and data orchestration vehicle of enterprise IT.

We believe the advances in GenAI, typified by the recent OpenAI launch of ChatGPT-4o (see analysis), are making it impossible for C-suite executives to ignore, and they need to find budget from legacy SaaS investments to help fund GenAI initiatives.

Market economics are playing a role, but enterprises are finally reaching a breaking point from being held hostage by SaaS premiums

Salesforce reported net income of $1.5 billion, up 7x year-on-year, and free cash flow of $6 billion, up 43%. Financial analysts attribute growth mainly to investors influencing CEO Mark Benioff to cut costs, reduce headcount, and rethink the business structure. However, guidance was very unlike Salesforce, as Q2 revenue growth is projected to be around 7%.

The alarming data shows that Salesforce is forecasting revenue growth of less than 10% for its next fiscal year. And for its next quarter, it’s anticipating basically flat revenue. If this guidance holds, the SaaS leader’s fiscal year will hit $37.7 billion in top-line revenue and $9 billion in operating cash flow. With its market cap dropping by 20%, the stock will have a $200 billion valuation. This results in the stock reflecting a trading level of about 20x operating cash flow.

Exhibit 1: Salesforce quarterly revenue growth has been slowing

Note: This chart shows the quarter-on-quarter growth/decline of subscription revenue from Salesforce 10Q filings from Q1 FY2020 to the present.
Source: Salesforce, FY 2020-2025 10Q Filings
https://investor.salesforce.com/financials/default.aspx

While there is truth to this, reflecting its revenue slowing down due to the economy. The need for technology to support ever-growing business needs—especially customer, product, and go-to-market efforts—raises alarms. But it’s not just Salesforce. As most independent software vendors (ISVs), SaaS, and cloud solutions have adopted subscription-based (monthly recurring revenue) models, this ‘bump in the road’ of enterprise spending is likely a very alarming sinkhole—likely upending the SaaS market that has been living high on the hog with premium, value-based pricing and revenues that have fueled equity and private investors for the past two decades.

Enterprise buying is shifting from SaaS to GenAI as SaaS premium pricing has finally driven companies to revolt

We see Salesforce as the “canary in the goldmine” because we have documented a dramatic shift in enterprise spending toward GenAI. This spending is critical as it can’t all be used to enable employee productivity. In HFS’s latest Pulse survey, most Global 2000 enterprises expect IT spending to increase between 6-10%. The spending on emerging technology, see Exhibit 2, will be at the upper end of this band.

Exhibit 2: Investments in artificial intelligence and data will outpace all other emerging IT spending categories

Source: HFS Pulse, 2024

The dollars that SaaS firms have been able to charge based on user, seat, or endpoint have become so significant that enterprises are eager to revisit what they can build, not using emerging AI technologies to refactor, rearchitect, and make new composable applications.

Additionally, we see competitors emerging that can quickly build modules or data-centric software (noApps) that can rapidly be adapted or actioned into use at fractions of the cost of third-party enterprise SaaS applications. This builds on HFS’s published point of view from 2021 that applications are in decline and data (the core of AI) is everything.

This event is the beginning of a more significant change, similar to what SaaS did to on-premises in the early 2000s

Salesforce won’t go down without fighting, and it might not go down. After all, it is also investing in generative AI, but this might not be enough. The vendor can expect to be faced with customers likely to be increasingly interested in reallocating investments from SaaS to GenAI fees that enable their teams to create value that scales beyond a single application or platform. As AI open-source tools become more available, this is likely going to accelerate a move away from enterprise SaaS.

This trend mirrors the way Salesforce itself led a charge to replace monolithic on-premises enterprise applications and ushered in the cloud era. To think that the company would be immune from being disrupted by a future technology is absurd. And HFS feels strongly that this disruption is here. The rapid adoption of generative AI solutions to drive software and business processes may only take months. Therefore, many SaaS vendors can expect this shift to increasingly impact sales pipelines, revenues, and their customer installed base.

Exhibit 3: The software changing of the guard as enterprise IT moves from monolithic to SaaS to composable applications

Source: HFS, 2024

GenAI will be the intelligent orchestrator of applications and data that enables companies to deliver desired functionality much more cheaply. And while all the functionalities might not be available at first, the startups and more nimble ISVs will get there even faster with GenAI before larger ISV/SaaS firms can pivot. So, while there is overlap, CIOs and their teams must begin preparing their talent, operating models, and skills to pivot to this new way of working.

HFS believes this shift will lead to a stark change in how businesses partner with IT and their technology services partners to use technology enablement to transform their business and drive operational boosts in productivity.

Exhibit 4: Begin by rethinking how you develop software to enable, transform, and empower

Source: HFS, 2024

Salesforce isn’t dying, but the winds of change are here—don’t say you weren’t warned

Salesforce is still a very successful company. It continues to be led by a CEO with a knack for aggressively compiling strategies needed to protect growth. It has also announced and begun executing on its own generative AI solutions. And, of course, Salesforce Customer Cloud remains critical for firms to model their client engagement solutions.

However, it will face the innovator’s dilemma that continues to be an absolute truth in the software industry. New models of software that bring value at a lower cost will disrupt incumbent solutions. Whereas Salesforce will need to appease its shareholders with a new GenAI product that is additive to its existing revenues, thus charging customers even more to be a Salesforce customer—this will force savvy CIOs to look at the capabilities of their GenAI investments, their increasing comfort with cloud, microservices, and composable applications, and the ability to combine these with data, action-based APIs, and cloud-native architectures to change how they build for a future state.

The Bottom Line: Generative AI will disrupt software-as-a-service by enabling firms to create composable applications based on universal, functional modules deployable across back- and front-office workflows.

Small companies and enterprises will fuel the growth of composable software, and generative AI-centric “noApps” will leverage GenAI action modules to manage data flow, APIs, architecture optimization, security, access, and business requirement documentation. This new framework for software will enable companies to quickly create, assemble, and deploy sustainable solutions.