Commentary: The state of software spending

By Andrew Bartels, Vice President

Forrester recently projected that U.S. business and government spending on purchased software will grow by 10 percent in 2004. In this document, we project spending for different categories of purchased software, as well as for the software that enterprises build themselves.

Spending on information enablers (business intelligence, portals and so on), systems management, security and desktop PC applications will outpace spending on enterprise applications and to a lesser degree spending on middleware. Custom software built to order by IT services companies will grow 13 percent thanks to low-cost offshore options, while software built internally by corporate IT staff will increase only 4 percent as companies focus on minor enhancements to existing deployments.

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When people think about software today, they primarily think of commercial software from leading software vendors, such as Microsoft, IBM, Oracle, SAP, Computer Associates International, Symantec, Veritas, BMC Software and Adobe Systems, just to name a few of the largest of thousands of software vendors. With commercial software becoming more capable, more adaptable, and more available for a wider range of specialized needs, it is no surprise that total U.S. enterprise spending in this category reached $119 billion in 2003 and will grow by 10 percent to $131 billion in 2004. Commercial software includes both packaged off-the-shelf software and component-based software that can be configured and customized by the purchaser. It has three main categories: infrastructure, middleware and applications.

Application software: Hot and cold
Each category of software spend has unique growth prospects:

• Software for systems management and security growing healthily. About $43 billion, or 18 percent, of U.S. software spending will go for systems management, application servers, integration, security, database management systems, development tools and similar middleware software. We expect this category to grow by 10 percent in 2004, led by systems management (12 percent) and security (11 percent). Spending on application servers, integration and database management, which was relatively strong in 2003 with 8 percent growth, will continue at that same pace.

• Application software continuing its rebound, except at the enterprise level. U.S. companies and nonprofits will spend about $76 billion, or 32 percent, on packaged applications and information enablers in 2004--an increase of 10 percent over 2003. Spending on desktop applications will grow 14 percent to about $18 billion, with Microsoft getting the lion's share. U.S. spending on information enablers, such as business intelligence, portals, enterprise content management and collaboration, will come in at $15 billion, up 15 percent. Meanwhile, enterprise process applications, such as financial management systems, human resources management systems, consumer relationship management, supply chain management, product life-cycle management and supplier relationship management will only slowly recover from the downturn of 2002 and 2003, with $27 billion in spending on licenses, maintenance, and services growing by just 6 percent from 2003. Enterprise vertical industry applications for financial services, health care, retail and other industries will be stronger, up 8 percent to $17 billion.

• Operating system and storage software growing more slowly than hardware. We estimate that $12 billion, or 5 percent, of U.S. software spending in 2004 will go for operating systems and storage software, with about three-fifths for operating systems of servers, mainframes and storage hardware, and the rest to PCs. Growing adoption of Linux will hold server operating system revenues down, with most of the 9 percent growth in this category coming from storage software. Increased PC sales will boost sales of PC operating system revenues to 10 percent.

Custom development: New life offshore
Twenty years ago, custom-developed software still dominated the commercial software segment, especially for enterprise operations and applications. However, the role of custom-developed software has steadily diminished as commercial packaged and semipackaged software has grown in sophistication and scope. Spending on custom-developed software by our calculations equaled $15 billion in 2003--one-eighth of the spending in commercial software overall. Governments--especially the federal government--have a disproportionate share of this market, due to their very specialized needs and limited resources for internal software development. However, the availability of low-cost, offshore development resources, which is being used increasingly by many businesses, especially in financial services and in high-tech, has recently reversed this trend. We project that spending on custom-developed software will equal $17 billion in 2004, up 13 percent from 2003.

Internally built software: The decline continues
Enterprises will continue to develop their own software to meet unique needs and requirements, and to adapt and customize packaged applications. But valuing this internal development work is challenging. Forrester has adopted the U.S. Commerce Department's calculations and historic numbers, which value investment in internally built software based on the value of the IT staff time devoted to it. Because we have a separate category for IT staff costs in our projections for total IT spending by businesses and governments, we include the value of internally built software in our IT salaries and benefits projections.

Investment in internally built software has been steadily declining year over year as commercial software has become more capable and customizable, and has been developed to support more business processes and adapted for different vertical industries. The Commerce Department calculates that investment in internally built software was $83 billion in 2003, and we project that it will grow by 4 percent to $86 billion in 2004. Governments, insurance companies, banks, utilities, retail and wholesale firms, health care companies, telecom companies, and manufacturers will make about half of these investments during 2004, while the other half comes from software vendors and other tech companies developing software for sales to others. Investment in internal software will continue to shrink as development needs of IT buying enterprises narrow to the creation of specific functions not available in commercial software or to extensions and adaptations, but investment in internally built software by IT vendors will grow as the market shifts to commercial software.

Recommendation: Look for discounts
While 8 percent growth in spending on software is not too shabby, software vendors became accustomed to seeing 15 percent to 20 percent growth rates from1996 to 2000--and so did their investors. That was particularly true in categories like enterprise applications, where growth of 25 percent to 30 percent was common. With stock prices still trading at relatively high multiples to earnings, vendors are heavily focused on sales growth to show that they are still deserving of these price-to-earnings multiples--consequently, they are willing to discount. IT buyers should still press aggressively for discounts despite growing news of economic recovery and the firming of prices.

© 2004, Forrester Research, Inc. All rights reserved. Information is based on best available resources. Opinions reflect judgment at the time and are subject to change.