“The cloud” may be taking over a key operational area sooner than you thought. Although many companies remain skittish about letting software-as-a-service applications manage sensitive data, SaaS is rising fast in the human-resources area to take on long-dominant, perhaps more robust, but surely more cumbersome on-premise systems.

Indeed, for many companies the chief remaining argument against choosing cloud-based HR-management tools is “stuckness.” Large companies have invested millions over the years in traditional enterprise resource planning providers (prominently SAP and Oracle) that have embedded HR systems and processes. You just don’t unplug an ERP two or five years after implementing it, even if you’re open to a different approach. Keeping the legacy ERP and adding  a different HR system may also be problematical, as they may not integrate well.

But the ice is clearly breaking. A Towers Watson survey of 628 companies (about half with less than 5,000 employees, one-third with 5,000–20,000 workers, and one-fifth with more than 20,000 staffers) in August reported that 24% had implemented a new human-capital management system (HCMS) in the previous 18 months. Among U.S. companies, 22% are currently implementing a new “primary” HR system or are planning to do so.

What Towers Watson calls “primary,” many observers call “core.” A core HR system is, very generally, one that keeps track of employees’ personal information and manages payroll, taxes, and benefits. Adding to those, the past decade has brought a torrent of new vendors selling “talent-management” applications for other HR-related activities, such as recruiting, performance management, succession planning, compensation management, onboarding, and career development.

Oracle, SAP, and other on-premise vendors have meanwhile added talent-management functionality to their on-premise offerings, but many of the new, independent talent-management products were developed “in the cloud.” While on-premise installations still hold a wide lead in the large-company HCMS market, growth in the newer tools’ overall popularity has led the traditional vendors to ramp up efforts to create and enhance their own HCMS presence in the cloud.

Those efforts took a big step forward early this year when SAP purchased SuccessFactors and Oracle acquired Taleo, two of the most successful cloud talent-management providers. Now their new parent companies are working to integrate those technologies with their existing ones even as they develop their own applications, such as Oracle’s new Fusion HCMS platform, which combines on-premise and cloud elements. (SuccessFactors, meanwhile, has completed its full-featured core HR system, Employee Central, enabling it to deliver end-to-end HCMS capabilities in the cloud.)

How long the integrations will take, and how they will change what the two big vendors bring to market, is a story in progress. But it’s a foregone conclusion that the HR market will continue to shift, bit by bit, to the cloud.

“Let’s not write off on-premise software just yet. There is a huge market of companies running those applications, and most aren’t going to rip them out tomorrow,” says Thomas Otter, the lead HR technology analyst at Gartner. “But clearly, if companies were starting from scratch today, a large majority would go with the newer solutions, which are typically all SaaS.”

A Growing Threat
Still-independent vendors of cloud-based talent-management applications include Kenexa, Ultimate Software, Cornerstone on Demand, and a plethora of others offering various pieces and combinations of what SAP and Oracle provide. In some cases, the smaller players are considered “best of breed” in their specialty areas. That was (and is) the case, for example, with Taleo’s recruiting application.

But the biggest concern for SAP and Oracle is a fast-growing company, Workday, that fits into no existing HCMS category and was likely the chief driver for the acquisitions of  SuccessFactors and Taleo.

Workday, says Otter, is aiming to be “a complete ERP in the cloud.” So far, its primary market focus has been HCMS, where it has a robust lineup of both core and talent-management applications. But it also now offers a broad suite of applications for almost every financial function, including core finance (general ledger, accounts payable, and accounts receivable), revenue management (contracts, billing, and revenue recognition), cash management, management reporting and analysis, governance and compliance, expense management, and procurement.

The only somewhat-comparable cloud player is NetSuite, which aims a broad set of financial and other tools (including HR-related ones) at the middle market, although it’s making headway with larger companies, too. Workday’s sights, however, are trained almost exclusively on companies with more than 1,000 employees.

“Workday is the first vendor that potentially can challenge the SAP/Oracle duopoly in the large-enterprise market,” says Otter. So far, it has proven that it can be a top-of-the-market contender in HCMS. “The company has gotten to the point where a customer of Oracle’s PeopleSoft [HCMS] can look at 20 years of PeopleSoft development, and then have a look at Workday [which launched in 2006], and pretty much see functional parity.”

And Workday is not exactly toiling in anonymity. It has scored an astounding $250 million in venture funding (based on a valuation of more than $2 billion), has 310-plus corporate customers, claims to be growing revenue at more than 100% per year, and in mid-August was reportedly planning to go public soon. (Workday declined comment on those reports.)

Market Jockeying
It’s difficult, still, to get a read on the precise extent of Workday’s  success. A Gartner report on 2011 market share in the HCMS space did not include Workday because, the analyst firm says, it was not publicly held, as most other significant players were.

The report showed that SAP had 18% of total HCMS software revenue (including licenses, subscriptions, and maintenance), and Oracle had 17%. Kronos, a company that provides core HR tools, had 8% of the market. Eight other companies, most selling talent-management tools, had less than 5% each, while 35% was attributed to “other vendors,” where Gartner says it lumped Workday “for the time being.”

On the other hand, in the 2011 version of Towers Watson’s recently released report, 18% of companies that had recently implemented a new HCMS, or said they planned to soon, had selected Workday – almost as many as SAP (22%) and more than Oracle (a combined 15% for its PeopleSoft and Oracle legacy systems).

But despite Otter’s current characterization of Workday as an ERP under construction, the company is loath to call itself that, as if leery of ERP’s reputation as expensive to buy, laborious to install and update, and all-too-often disappointing operationally. “We are not positioned as an ERP,” says Leighanne Levensaler, the company’s vice president of product strategy. “We are an alternative to an ERP. We have a highly configurable, adaptive solution in the cloud. To call it an ERP limits its scope. We can solve problems companies have because of architectural decisions [ERP vendors] made long ago that didn’t consider there would be changes in the global landscape, regulatory changes and associated new reporting requirements, and new ways of managing people.”

Neither SAP nor Oracle responded to requests to provide input for this article.

Cloud Appeal
As noted, the HCMS market extends well beyond SAP, Oracle, and Workday. But why is the latter company a growing threat to the longtime market leaders, and for that matter, why are cloud technologies in general gaining favor?

New, cloud-based systems are typically easier to use than on-premise legacy systems. This year’s Towers Watson survey shows that Workday’s user interface was its chief selling point for customers (58% of respondents included that factor in their top 3 among 10 factors listed). “It’s easier for HR to use, easier for employees, and easier for managers,” says Derek Beebe, Americas HR technology sales and marketing leader for Towers Watson, which also markets its own HR tools.

Ease of use was followed closely by “lower ongoing costs” for hardware, IT support, and system maintenance compared with on-premise solutions as a reason for moving to the
cloud, cited by 53% of the Towers Watson respondents. But that doesn’t mean a cloud solution is always better for the bottom line.

“Less hardware and fewer bodies are needed, but that will be partly offset by paying monthly or annual subscription fees versus a one-time payment for the software, and you won’t be able to capitalize the investment,” Beebe notes. “So will it always net out as less expensive to go cloud? No. But the fixed costs are lower, and for some people that’s important.”

But it’s not all about cost. Beebe says that based on analyses of its survey responses, Towers Watson has concluded that with a cloud solution, on average “you will see a 1.25 times greater effectiveness at achieving your business objectives. We spent a long time looking at the data and validating it with our clients to make sure what they said is what they meant.”

That’s why, says Beebe, some customers of Taleo and Oracle worry about the industry consolidation that brought them to Oracle and SuccessFactors, respectively. “Every day we get calls,” he says. “They had reasons for picking a specialized vendor, like innovation, speed, usability, and responsiveness. Now they fear that decision may be undone a bit because their provider is now part of a much bigger organization.”

Also, to Levensaler’s point about adaptability, updates are time-consuming with on-premise systems. “Workday is delivering three major product updates per year. There’s no way an on-premise vendor could do that,” Otter says. “The company’s IT department could not be prepared to manage it. That has made Workday very competitive.”

And, says Beebe, the window of opportunity for cloud-based systems is so much the wider because some corporate executives who decided to buy the on-premise tools are now, several years later, leaving their organizations. Maybe they had a vested interest in maintaining the system, but now there are new managers who see capability gaps or that the company no longer has the head count to manage the installed infrastructure.

Beware the Piecemeal Approach
The opportunity to adopt cloud systems often arises as companies decide that “we’ve never implemented, say, e-recruitment or e-compensation planning, and it will cost a lot to do that with our on-premise vendor, so we’ll use Taleo or SuccessFactors or pick up a piece of Workday,” says David Watts, SAP HR project manager for Clarkston Consulting. But, he warns, that way of thinking could risk a reversion to the siloed approach to enterprise applications in which disparate solutions are not truly integrated, which was a key reason ERPs were developed.

In Watts’s view, companies are beginning to embrace cloud-based technologies for human-capital management to a greater extent than they have for many other functions because of the way they perceive HR. “Some of what HR does is mission-critical — payroll, certainly — but if talent-management applications go down for a little while, that’s not the end of the world. The company can still book orders and ship product. So IT has been more willing to give HR some rope.” Cloud technologies may, however, have data-security implications, though many experts consider those to be overblown.

But the decision of cloud versus on-premise may not be the end-all, be-all of HCMS. “There’s cloud done well and there’s cloud done badly,” says Gartner’s Otter. “A good on-premise solution will beat a bad cloud solution.”