Jun 4, 2001 12:00 PM,

Blazing a trail to profitability

by Pascal Aguirre

The application service provider ecosystem is fertile. It will soon prove to have been one of the most significant and strategic developments in the history of information technology. Of course, this space has had its share of problems and growing pains, but these can be eased with the right methods.

All in the execution

However, as it often has been the case in many other nascent industry spaces, the pioneers are struggling to effectively execute this breakthrough concept.

Many ASPs are experiencing significant operating losses and are severely out of favor in the equity markets. In-depth analyses of the economic performance of many of the leading publicly traded ASPs suggest that on average, they are posting twice the amount of losses as they do revenue.

Although many ASP executives see this as a temporary by-product of being in start-up mode, a close look at activity-based costs — and, more important, their dynamic behavior as the company scales — reveals that some important structural issues must be addressed in the business model. Here are some reflections on the principal shortcomings of the current approach to applications hosting, including six prescriptions on what is required to get back to profitable growth and build an effective second-generation ASP.

Become facilities-based and vary the revenue mix. Most ASPs have genuflected at the altar of the “pure play” to simplify access to public funding. As a result, most players resell other people's Web hosting, and the lion's share of revenue comes from non-recurring professional services (Figure 3).

Curiously, a small proportion of revenues comes from application rental fees. Certain providers derive as much as 90% of their revenues from integration services, and very few actually capitalize on the economic synergy of ASPs and hosting.

The fact is that given its current size, and competitive and technical dynamics, the ASP industry cannot support such a fragmented value chain. There simply is not enough business in this space to support so many “pure-play” ASP and Web hosts that need to rely on essentially similar infrastructure platforms, sell to the same customers and deploy the same operational and customer support capabilities. Successful ASPs will need to merge with Web hosts in order to decrease their revenue reliance on professional services, and retain more value by selling the hosting infrastructure and the application hosting capability that rides on it.
Increase prices and modify billing dynamics. An in-depth look at the economic models of many ASPs reveals an alarming reality: Very often, the incremental revenue associated with turning up a customer is overshadowed by the direct, incremental cost of doing so. This difference is known to cost accountants as a negative contribution margin.

Many believe that losses will disappear as the company scales. However, while absolute losses can ultimately be erased through volume when a positive contribution margin exists, a negative contribution margin only worsens the economic picture as the company grows.

In some cases, Adventis estimates that product contribution margins will be negative by as much as 11% (Figure 4). Furthermore, we still cannot rule out the possibility that contribution margin actually worsens as a single client's consumption of the service increases since more bandwidth, storage and support requirements are generated.

To achieve positive contribution margins, ASPs will need to cease pricing as aggressively as they are. Focused and controlled profitable growth will be far superior to exponential, unprofitable growth. In addition to raising prices moderately, more sophisticated pricing models must be developed.

Currently, the predominant basis for billing is a monthly flat rate per user for unlimited use. Under this model, the only way the ASP can derive more revenue is to add more users. A more effective pricing model will have to accommodate a variety of variables such as number of transactions, quality metrics and resource usage parameters to more effectively capture marginal revenue every time a customer causes the provider to incur marginal cost.
Deploy a robust operations support systems (OSS) platform. OSSs are well known to telecommunications companies. And OSS limitations are also well-known. These applications are the lifeblood of a network business and act as an air traffic controller that enables a service provider to deploy certain services and features, to activate a customer's service, to monitor and fine-tune the network, to repair it, and to bill customers.

Operational excellence and profitability improve geometrically as a function of OSS quality and flexibility. Sophisticated OSS suites exist for communications networks and equally impressive ones are available for computing networks. However, ASPs face the following challenge: There are currently no OSS suites for converged networks. This is perhaps the single most critical area of technical focus for ASPs.

Market leadership will accrue to the first providers that have effectively cooperated with their vendors to evolve a next-generation OSS suite that is network and application aware.

Ultimately, it is imperative that ASP and Web hosts deploy an architecture that enables automated provisioning and management of services as well as the sharing of technology infrastructure across many customers.
Focus on the mainstream. For somewhat obvious reasons, the current distribution of ASP customers is heavily skewed toward the rapidly evaporating dotcom sector of the economy. In some cases, as much as 50% of customers are dotcoms, and up to 90% of customers are in the technology sector. These types of customers exhibited a rare blend of technology centricity, need for speed, profuse funding and willingness to experience that motivated them to be early adopters of ASP offerings.

In parallel, ASPs are attempting to penetrate the high-end enterprise markets to legitimize the value of their services and solidify their business footing. The nature of an ASP offer, however, is better suited to the mass-business markets for two reasons.

First, there are fewer legacy systems to deal with and often little installed base to compete with. Many large enterprises have already deployed client/server applications that make the sale of an ASP offer more difficult.

Second, the number of total potential users within a smaller company makes the business case for a pay-per-use application service more attractive than the premises-based alternative (Figure 5). Typically, the best industry sectors on which to focus should have complex value chains and fragmented industry structures.
Become an information utility. Several ASPs are attempting to market to key verticals; however, the approach is still by and large to market to a broad set of industries. In the initial stages, the best way to eliminate overreliance on professional services is to reduce the number of targeted industries while expanding the offer portfolio that is marketed to them.

By becoming the “information utility” of choice of a certain industry, ASPs can more rapidly and effectively gain scale and market traction. The objective is to replicate the approach that Sabre or Sita/Equant have had in the travel and transportation verticals, respectively. While these companies are typically not thought of as ASPs, in both cases their offer suite extends from connectivity services to applications hosting and outsourcing.

An intimate understanding of their customers' business processes coupled with laser-like channel focus are allowing these two providers to command an impressive competitive presence in their target industries and to scale profitably on an EBITDA basis.

Already, we are seeing large-scale success in the health care sector from ASPs that have developed deep expertise on the operational processes of their customers.
Explore select asset-intensive outsourcing. Cracking the code of the sophisticated enterprise market will prove difficult without adding two key ingredients to the value proposition. First, ASPs will have to augment their offer with a compelling managed network services capability.

For many large enterprises, the headache and cost associated with managing their overall IT infrastructure far outweighs that of deploying a particular application package. Therefore, an appealing value proposition would entail not only providing “application tone” to a corporation but also the traffic management, element surveillance and subscriber management of their technology infrastructure.

The most extreme form of this service would transfer the customer's people and assets in a full outsourcing contract. The ability to understand and operate these types of services also positions business process outsourcers as interesting potential contenders for leadership in the next chapter of the ASP saga.

A new landscape

Application hosting will dramatically alter the face and nature of the information technology business. However, the main issue with the ASP space is that it has been approached as a stand-alone business rather than as a strategic product line of the hosting or telecommunications business.

After a decade of turbulence, innovation and experimentation, these sectors are ripe for a rationalization of many business models and for the advent of a new breed of provider: the convergent solution provider.

Leading convergent solution providers will leverage network and hosting facilities to provide integrated bundles of managed services and application hosting.

In the 20th century bandwidth and processing capacity were the application, but in the 21st century they will merely enable it.

Application outcome, value, variety and velocity will be crowned as the yardsticks of industry leadership, and as is often the case in sectors that revolutionize an industry, many will be called, but few will be chosen.

Pascal Aguirre is vice-president, global practice leader for convergent solution providers for Adventis. His e-mail address is paguirre@adventis.com.