Jan 29, 2001 12:00 PM,

Enabling the ENABLERS

by Kneko Burney

The heat's on for applications infrastructure services

Going out of business?

The ASP space seemed like a sure thing a couple of years ago. However, this industry still is evolving, with many players still unable to find a sustainable, profitable value proposition.

Successfully playing in the ASP arena is no easy task and generally requires that firms have one of two things at minimum—ideally both:

Existing (deep) relationships with customers
The ability to provide the customers with services and support in addition to hosted applications, namely services unique to the customer's requirements.

Unfortunately, most of the pure-play ASPs that have emerged over the last couple of years cannot do either of these things, casting doubt on the future of this particular business model. So the prediction of the year is In-Stat does not expect pure-play ASPs, firms that neither develop nor integrate the applications they host, to have much of an addressable market opportunity in the medium to large-term.

In contrast, companies with existing businesses in technology services—namely integrators, developers and value-added resellers—are likely to enjoy the most success with hosted apps now and in the future, particularly as these firms are able to leverage more affordable applications infrastructure services in the coming year.

Application services will outlive pure-play ASPs. As a growing number of “grass-roots” technology providers begin to embrace the idea of offering their customers hosted applications, Internet accessibility will soon become a necessity for today's businesses. Up to half the work force in the enterprise market is located in remote sites (home and branch offices and mobile workers), almost requiring an Internet-accessible operating infrastructure to keep these employees connected and productive.

Given this, hosted applications (through a provider or done in-house) could eliminate the remote management challenge for larger firms, and for smaller companies can allow them to take full part in the Internet economy without the burden of complex systems, network and software infrastructure.

ASP roots

Given the promising future for both the application services, the talent pool currently playing in the space is diverse. Based on interviews with top IT decision-makers at 100 firms, In-Stat found that most companies offering hosted applications in 1999 or planning to do so in 2000 were quite varied in their roots, though the largest segment of these firms could be considered “telcos.”

Existing service providers, namely competitive local exchange carriers (CLECs), are probably in the best position to offer hosted applications in the near-term. More important, they have the needed billing and provisioning systems to offer a recurring revenue stream such as this with relative ease.

Of more interest, roughly a quarter of the nearly 100 ASPs identified in 1999 were classified as “pure-plays,” with the percentage of these firms expected to have fallen slightly in 2000. The influx of traditional providers such as value-added resellers (VARs) and integrators offering hosted applications is believed to have outpaced the growth in start-ups, particularly when looking at the funding climate for pure-play ASPs by the middle of 2000.

Even in 1999, traditional providers accounted for nearly 50% of the firms offering hosted applications at that time. This is fairly good new for firms getting into the applications infrastructure space, as many of these traditional providers are outgrowing their in-house hosting infrastructure, leading them to look to infrastructure services for cost-effective expansion.

The ASP infrastructure look

For the most part, companies hosting applications in 1999 and 2000 co-located their infrastructure, investing in servers and networking hardware. Larger firms in the space built their own data centers to support their application services business. In either case, the research clearly showed that ASPs in 1999 and 2000 have been focused on developing their application hosting capabilities internally.

However, In-Stat believes this trend will start changing in 2001.

In-Stat estimates that the average ASP managed more than 30 servers in 1999, with this number reflecting the diversity in size of most players in this space at that time.

With the market still evolving and growing early in 2000, a significant increase in the number of servers installed in ASPs' data centers was expected, with the average number of servers supported increasing to more than 100 between 1999 and 2000. However, much of this expected jump was fueled by most players' steep customer-base projection between the two years. Much of that growth did not take place, suggesting that many firms have sustained or even scaled back their in-house systems infrastructure to contain costs.

Table 1 Spending on IT infrastructure and services

Total U.S. ASP community

	%	1999
Software	17%	$ 72,583,062	13%	$ 120,989,089
Hardware (systems and network)	27%	119,046,723	34%	310,203,152
Telecommunications	19%	83,127,076	19%	173,206,200
Personnel	25%	110,252,753	19%	172,294,588
Outside services	8%	35,000,874	10%	94,807,604
Other	4%	17,500,437	4%	40,110,909
Allocation of IT budget	100%	$437,510,924	100%	$911,611,543
Source: Cahners In-Stat Group

Network hardware and services are core to business, connecting to the backbone is top priority for these firms and considered by most IT planners in this segment to be primarily the work of router solutions. However, the cost-effectiveness of high-end L3 and L4 switches already was gaining some ground in 1999.

In-Stat research indicated that many providers were seeking to increase the number of L3 and L4 switches as they grow rather than purchase additional router products. These results are indicative of the continued development of high-end switch technologies, particularly L4 solutions.

L4 switching technology was still gaining acceptance in 2000, which has led some ASPs to more carefully consider their options for server connectivity in 1999 and 2000, possibly beyond. Looking forward, L4 switches will likely absorb much of the growing demand for both load-balancing and backbone connectivity in this segment, though routers will remain the heart of the network core in firms maintaining their own infrastructure.

The broader the band

Beyond a pronounced increase in connectivity requirements for voice and data during the last couple of years and an evident shift toward broadband, In-Stat research suggests that the “application services” business model of choice is rooted in bundled or packaged services. Most firms in 1999 and 2000 were taking an “everything to everyone” approach, with players offering high-speed connectivity as a core component of their application services solutions.

With this in mind, it's not surprising that the average ASP supported more than 100 broadband lines in 1999 (with less than 30 customers) and expected to increase its requirements to roughly 160 lines in 2000.

Much of this growth was to support customer connectivity requirements, where the inclusion of broadband Internet connectivity addressed a key problem facing more hosted applications providers: last-mile connectivity and control. By integrating public access into the hosted application offering, ASPs can provide better quality of service (QOS), while increasing their revenue share (and improve their value proposition).

Spending on infrastructure

In-Stat estimates that the combined population of U.S.-based ASPs—estimated to be more than 100 firms at the end of 1999—spent nearly $440 million on IT infrastructure and services in 1999. Granted, many of these firms already were significant buyers of IT products and services at that time. However, In-Stat believes the increased requirements of offering hosted applications affected their traditional IT budgets by at least 15% in 1999, with the additional increase estimated to be more than 20% in 2000.

Indicative of continued growth in the ASP community, In-Stat estimates U.S-based ASPs (estimated to be nearly 200 firms) spent nearly $1 billion on IT infrastructure and services. Though the opportunities are significant for all vendors of enabling technologies for this market, the key area of spending growth between 1999 and 2000 was on core hardware, particularly systems (Table 1).

Looking forward, the efficiencies offered by emerging applications infrastructure providers, namely those able to enhance or improve customer acquisition, are likely to seriously cut into the future growth prospects of systems hardware expenditures in this segment although application infrastructure providers' growing requirements should absorb the displaced market expansion.

Instead, the key area of growth is expected to be in outside services expenditures among ASPs, which was estimated to have almost tripled in size between 1999 and 2000.

Is there a market?

With the application services “industry” having had a couple of years to discover some of its key success practices, the interest of firms to continue to build internal data center capabilities is waning. Further, the influx of traditional technology providers such as VARs and integrators presents infrastructure players with a fresh stream of customers with interest in hosting applications, though none in building data centers.

Even at an early stage in the ASP market, when it was more common to develop internal data centers, many firms outsourced something in 1999.

Cahners In-Stat research shows that roughly 40% of ASPs outsourced some element of their core IT infrastructure at that time, and more than 50% planned to do so in 2000. Looking into 2001 and beyond, as much as 60% to 70% of ASPs are expected to turn to infrastructure providers to either replace or augment their existing capabilities, while most “newbies” getting into the hosted applications game expected to turn to an outsource provider for the needed infrastructure.

So what about the 20% of the ASPs not outsourcing in 1999 that were unsure if they'd need outside services in 2000? In-Stat believes these results indicate three key things:

Firms invested big sums to build in-house capacity early on, believing they could control the back-end and the needed public network services effectively on their own
Many ASPs underestimated the infrastructure requirements necessary to really support QOS demands from a growing customer base and/or underestimated the challenges billing and operations support would present
There was no clear outsourcing infrastructure solution for ASPs in 1999, exclusive of co-location services

Though major providers such as Qwest Communications, IBM and, recently, AT&T began offering application infrastructure services at the end of 1999, this concept just recently started to resonate in this evolving market.

Given this, it is not surprising that most ASPs looked to outside providers for things such as applications development and Web hosting in 1999. Interestingly enough, the research also shows that more than half of those using outside services used services to add server capacity, with roughly one-third outsourcing some of their storage needs. This is a point of validation for the applications infrastructure space, particularly as this segment continues to emerge and look for cost-effective alternatives to building in-house.

In the long run

In-Stat expects demand for outside services within the ASP community to increase. As more technology providers, those that do not traditionally offer recurring services, seek to offer hosted applications, the needs of the application services marketplace will swell.

Basically, it doesn't make sense for everyone to build a data center. The economies of scale that application infrastructure providers can offer to smaller players are unquestionable, especially when simply augmenting their existing business with hosted applications.

This is good news to the more than 50 firms currently offering applications infrastructure services in the U.S. This group includes major telcos such as Qwest, AT&T, Sprint and Cable & Wireless, as well as fairly new faces such as Chapter 2, Nupremis and GlobalApp. In-Stat is not sure that the applications infrastructure market is large enough to sustain 50 or more firms in the coming years, though several niche markets are likely to emerge quickly. Regional and smaller-scale providers focused on specific segments of the ASP/would-be-ASP marketplace are likely to carve out interesting opportunities, where most small VARs and integrators getting in the hosted applications business will seek out a localized infrastructure provider.

In the long term, In-Stat believes major backbone providers will likely have some edge in the applications infrastructure space. Though many believe that network service providers manage their data centers poorly, the integration of the data center with the network is not only inevitable, but necessary for the success of the hosted applications business model in the long term.

Given this, major providers already have the most difficult element of infrastructure in their control, the network, giving them an advantage over other players. This is not to say network-neutral firms won't be successful, though they may not be able to enjoy the same level of profitability, bearing the cost of the network services in addition to that of the data center.

The missing link

Telecom providers are a key piece in the value chain, not only because telcos have the network services needed to succeed, and the resources to continue to build state-of-the-art data centers, but they also can aid in customer acquisition, particularly for firms new to the ongoing services marketplace. This should create a circle of demand for service providers that can integrate and manage their infrastructure and hosted applications businesses.

The more ASPs telcos enable, the greater the increase in both their application services and VAR/integrator capabilities to sell-through to customers. If these capabilities are effectively dispatched to customers, ASPs will be attracted in droves, feeding the cycle.

In-Stat believes major telcos need to involve themselves in the infrastructure services market, as hosted applications are likely to become a key means of developing revenue opportunities beyond connectivity and reducing churn in the longer term. Furthermore, some telecom providers hope to use application services to spur demand for broadband connectivity in smaller firms and pave the way for a more robust relationship with these customers, which is likely to be a successful market strategy.

Outside the small company market, telcos with application infrastructure services are likely to sustain relationships with their biggest customers, enterprises, which currently are struggling with the challenge of Internet-enabling many of their internal business applications.

Infrastructure services also will become a key means of growing revenue opportunities and relationships with these lucrative customers and are likely to also help service providers better serve firms in the middle market as well.

Kneko Burney is Director of e-Business Infrastructure and Services for Cahners In-Stat Group in Scottsdale, Ariz. Her e-mail address is kburney@instat.com.