Prior to Q2 earnings, I had a thesis that macro-induced pressure on enterprise IT budgets would result in consolidation of point solutions, favoring platform providers with a suite of product offerings. The idea is that technology budget owners (CIO, CTO, CISO) look for opportunities to reduce costs by eliminating redundant services and trying to concentrate spend onto fewer vendor platforms. This consolidation usually results in savings through volume discounts, fewer contracts and less operational overhead. It can also allow staff to be repurposed, who may have been dedicated to managing a particular vendor point solution.

The scope of consolidation can extend to open source projects or DIY internal solutions as well. These efforts are often appealing on the surface - the software license is free. However, they require commitment of the most expensive resource in an IT organization, namely engineers, to make them work. Faced with hiring freezes, IT leaders can repurpose software engineers who were managing these internal efforts to fill staffing needs supporting applications tied to revenue. They can then replace the open source service with a commercial managed service, often reducing cost. A fully loaded software engineer expense can reach $200-300k per year or more (considering total package of salary, benefits, office support, SBC, etc.). It doesn't take many engineers to cover the cost of a commercial product.

Now that last quarter's results are largely behind us for software infrastructure companies, we can revisit this idea to see if there was evidence of this consolidation activity. As it turns out, several software infrastructure companies noted this trend as part of their earnings report commentary and prepared remarks. Given that these kinds of consolidation efforts can take time, we will likely continue to see this theme play out. This will have implications for software vendors, with the outcome that providers of a suite of services will be better positioned in this market than smaller players with fewer offerings or point solutions. Additionally, we should see a thinning of the competitive set, as smaller private companies cut back their staffing investments and have more difficulty winning deals.

As a result of these conditions, many enterprises took advantage of the opportunity to consolidate vendor offerings to reduce costs. They also began migrating away from DIY or open source projects to an outsourced solution. I imagine that smaller upstart companies with a great product in a single segment had more difficulty closing deals. When every contract has to be scrutinized by the Finance team, an IT budget owner will be less likely to go to bat for an unrecognized, up-and-comer.

The platform vendor's offering can even be favored when the point solution provides a more complete feature set. An offering that is "good enough" for a particular segment becomes more compelling if its adoption can drive costs savings. In times of IT budget compression, idealized arguments for full-featured point solutions or the flexibility of DIY projects fall away quickly when jobs are on the line.

These themes were reflected in commentary and prepared remarks from several of the security and software infrastructure companies that reported earnings over the past month. Here are some snippets to illustrate the point.

There is a distinction with the timeframe and level of effort for software infrastructure consolidation. At the top level, services that integrate through an installed software agent (like observability and security monitoring) can be swapped out pretty easily. These likely saw more consolidation activity in the prior quarter. At the other end of the spectrum would be databases, where a data migration and code changes would be required to move more application workloads onto a single platform. In the middle might be some application security services, Zero Trust and application delivery (like CDN). The more difficult consolidation efforts may be underway, but the business benefit for the new platform provider will take a few more quarters to realize. Investors can expect benefit for software infrastructure platform providers within varying timeframes, depending on the complexity of the consolidation effort.

The other benefit to the leading platform providers from these macro pressures will be the crowding out of smaller competitors entering the market with one or two point solutions. When IT budgets were flush, technology leaders could place a lot of bets on niche software infrastructure providers, in the hope that a few would emerge to deliver real competitive advantage for their teams. As IT budgets compress, the opposite effect takes place. IT leaders will have to justify bets on smaller providers with little name recognition. It's easier to convince a CFO to approve an IT budget line item for a brand name platform provider that checks several boxes.

While the macro environment is pressuring the growth rates of leading public companies in each category, most are still applying their large cash balances towards hiring more sales people and engineers. Their smaller, VC-backed competitors don't have this luxury. Most are freezing hiring in an effort to reduce cash burn and extend their runway. Public companies do take a hit on their stock price by reducing operating margin, but private companies generally don't have the option to keep spending in preparation for macro headwinds receding. Their VC backers want to avoid the dreaded down round.

This scenario will leave a lot of business for the category leaders to mop up, which I think we started to see in the last quarter. Most leading software infrastructure companies performed better than expected, considering the macro backdrop. This trend will likely continue. When the macro headwinds abate, the category leaders will be well positioned to capture the return of IT spend, before the smaller competitors can ramp up their sales efforts.

Combined, I think these factors of consolidation and culling of the competitive set will ultimately benefit the companies that are recognized as leaders in their categories and offer a platform of multiple services. Investors can look for companies that are modern, but established, enjoying high growth (shows relevance) and offering multiple related product modules that are easily bundled. While the macro environment is pressuring their growth currently, these providers could re-accelerate quickly as enterprise IT budgets relax. And their enterprise customers will have fewer competing vendors knocking on their doors.