Winners and losers

Many application service providers have fallen far from the pedestal they graced only a year ago. The ASP market itself is still very much in play, but only those providers that have a viable business design will prevail

What a difference a year makes. Last year, application service providers seemed like the next tech-sector value rocket. Everyone wanted a piece of the action. Now all the hype has vanished, replaced by skepticism and claims that the ASP game is already over.

Value at  the frontier

If there is one thing the past year teaches, however, it's not to believe everything you read in the trend-driven press. The fact is, many profitable businesses have been created in network-centric computing. These successes have been overshadowed by spectacular flameouts such as Pandesic, Red Gorilla and HotOffice, and high-profile dramas such as USInternetworking, Interliant and Corio.

Understanding the ASP space requires facts, perspective and a detailed knowledge of customer priorities. Even the term “application service provider” is dangerously imprecise.

Mercer Management Consulting has identified 10 distinct business designs in what is better called the “xSP” space. As illustrated in Figure 1 and Figure 2, these xSP business designs can be grouped into asset-intensive “application infrastructure providers” and people-intensive “application service providers.” This article will focus on the infrastructure providers that appear “below the line on Figure 1.

What went wrong?

Last year's frenzy to create Web sites and host e-commerce engines created what seemed like a once-in-a-lifetime tide of prosperity for hosting and application infrastructure providers. But as the first wave of e-enablement subsided, so did the value of many of these providers' business designs. How did so many investments and business plans go awry? Let us count the ways:

• Because dotcoms were the early adopters for hosting and infrastructure services, the B2C and B2B implosion coupled with the ill-timed capital-market chill destroyed in some cases more than 90% of the market value of early providers.

  Round one winners such as IBM Global Services and AT&T Business Solutions were not dependent on dotcom revenue streams but business with pre-existing customers. Such established players, with strong customer relationships, rock-solid reputations and a brand that allows them to compete in the xSP infrastructure space, are well-positioned to solidify their positions in the year ahead.

• While billions of dollars of shareholder value has been taken from the table, the physical assets bandwidth, fiber rings and data centers have not. These assets now amount to substantial overcapacity with the prospect of limited future returns. The problem is especially grave in data centers, where many glorified real-estate developers put up space they hoped to rent by the foot. Utilization estimates run under 50% well below break-even.

Winners in this asset-laden space are either companies whose platforms satisfied customer requirements for specific underlying “-ilities” such as scalability, reliability, manageability and security or companies such as Akamai, Digex, and Digital Island that from day one offered complex specialized managed services like content distribution. Providers that can deliver these value-add services will be able to deepen and broaden their offerings, segment the market and allow customers to choose from a range of services either a la carte or bundled. They will also be able to buy undervalued assets and establish advantageous partnerships with hard-pressed commodity providers.

• Several aggressive infrastructure players made ambitious and premature forays into providing applications. But supporting applications in a hosted environment especially mission-critical applications surprisingly has not been much more difficult than providing co-located hosting. Infrastructure providers moving “up the stack” also learned that corporate heads of marketing, human resources, production, finance and other functional departments drive major application purchase decisions. These providers rarely had deep relationships with such buyers, who had strong preferences for established brands such as SAP and Siebel.

  The infrastructure providers that successfully moved beyond basic co-location had to stitch together a series of middleware and management systems, staff up with deeply skilled people and aggressively build brand equity in this xSP space. Going forward, software, business process and applications management providers should become a core customer segment. Mercer predicts that thousands of these service providers will exist, but only a few application infrastructure providers will survive. So a real opportunity and source of differentiation will be an ability to partner with such players and become their platform of choice.

The infrastructure providers that successfully moved beyond basic co-location had to stitch together a series of middleware and management systems, staff up with deeply skilled people and aggressively build brand equity in this xSP space. Going forward, software, business process and applications management providers should become a core customer segment. Mercer predicts that thousands of these service providers will exist, but only a few application infrastructure providers will survive. So a real opportunity and source of differentiation will be an ability to partner with such players and become their platform of choice.

The strong survive

What business designs proved resilient? While the short-term outlook for infrastructure providers seems bleak, the long-term prospects for those with superior business designs remain strong. The good news for those still standing is that the industry is growing up. Last year the focus was on cool new technologies, first-mover advantage and rapid expansion. This year there is a sober emphasis on business design, brand and staying power.

Moreover, current economic and capital market conditions have actually increased the pressure on enterprise decision-makers to pursue outsourcing solutions across their value chains. So service providers that can demonstrate expertise and quality of service should find more interest in offers to host, co-locate or manage applications.

Most industries have room for a low-cost supplier of a commodity product, and there will be a market for the basic co-location hosts. This business design, however, will never deliver superior profitability. Because the activity requires scale to be competitive, the major communications providers should eventually own this space, leaving some room for ruthlessly cost-obsessed suppliers like Level 3 Communications. But the clear movement in value creation is toward managed hosting models.

The last few years have seen the emergence of point infrastructure service providers that specialize in particular managed hosting services. Akamai and Digital Island provide content distribution networks; StorageWay, Storage Networks and Driveway sell storage; and still other companies offer security.

Customer research, however, suggests that these providers are vulnerable; their point solutions appeal primarily to specific niches. General application infrastructure providers with superior cornerstone positions and a wider array of offerings are well-positioned to steal their customers.

In the year ahead, the battle in the managed infrastructure space will be a true clash of titans. Entering as managed application infrastructure providers from above are major IT outsourcers including IBM and EDS; entering from below are major communications providers such as AT&T, Qwest Communications and Cable & Wireless. These powerful incumbents all have solid customer relationships, brand equity and proven xSP capabilities.

When worlds collide

Communications service providers eager to exit the commodity voice business have been especially aggressive, targeting the xSP space as a way to more profitably leverage their existing networks, data centers and operational skill set. Acquisitions to hasten the process provide a clear indication of this strategic imperative: WorldCom bought Digex, C&W bought Digital Island, and NTT bought Verio.

In trying to drive value up the stack, communications companies are positioning themselves as application infrastructure providers: Metromedia Fiber Network acquired SiteSmith.com, and Allegiance Telecom acquired Virtualis. Qwest's joint venture with KPMG, Qwest Cyber.Solutions, and C&W's a-Services initiative seek to take the communications providers across the line into actual application management but the long-term viability of such moves still must be proved.

The traditional IT outsourcing powerhouses EDS, IBM Global Services and CSC tend to discount the forays of the communications providers as gloried “power, pipe and ping” providers. They view communications as commodity businesses and believe the real value lies in knowledge of the applications and how they interact with the infrastructure layers.

But the two camps rarely realize how rapidly their worlds collide. The first bumps have come in content distribution networks and “digital asset management.” But both sets of players see storage, security and other next-generation managed services as major growth opportunities and plan to leverage their assets, incrementally add key services and expand their franchises to occupy this space.

As the titans battle over the application infrastructure provider space, they must also contend with a potentially pesky competitor: managed service providers such as Loudcloud at SiteSmith. This business design offers a similar range of application infrastructure services, but without ownership of the underlying assets. These players contract for hosting capacity from a co-location provider and add their layer of services such as security and service level agreement (SLA) monitoring on top. If the incumbents invest wisely in this space, however, these pure plays may not have staying power. As previously noted, SiteSmith has already been acquired by MFN.

While Exodus Communications and other high-fliers received all the publicity in the last few years, traditional players including IBM, EDS, AT&T, Qwest and C&W have emerged as the leading infrastructure providers. After an inevitable consolidation in this space, companies with the necessary scale, capabilities, brand and marketing prowess and that deliver well-targeted value propositions should emerge as the winners.

Compared with last year's expectations, however, traditional players will not find it a sexy, high-margin business. Over the near term, there is too much overcapacity and competitive intensity. There are parts of the business that never earn a dollar but are critical elements of a larger value bundle. Nonetheless, there are profits to be had for companies that leverage current customer relationships, build on existing operational capabilities and incrementally and shrewdly add valuable customer services.

Going forward

The industry is still in the early stages of a long-term structural shift toward network-centric computing. Most enterprise customers are only now considering this approach to managing their business processes. While an xSP solution will not be best for every company and application, the long-term direction is clear. Despite some spectacular failures, the game is hardly over. The big wave of adoption and revenue growth for network-centric computing lies ahead.

The industry has just passed through a costly trial-and-error process that answered some fundamental questions. Experience has taught the vital importance of a well-conceived and executed business design one based on a deep understanding of customers, their economics and their definition of value.

Customers are smart. They want functionality, security, flexibility and service, not just a low price and the latest piece of cool. And they will not adopt a new technology before they are ready. If you know how to ask and listen, your customers will tell you what features and variables are critical, which are not, and when the time is right to move forward.

In addition to a superior, customer-centric value proposition, successful competitors will need to continuously refine their profit model. Communications providers entered the hosting business to build load for their data networks only to find that utilization of both sets of assets is running well below capacity. Countless xSP business plans still assume hockey-stick demand increases yielding break-even results in the next two years.

These expectations are fundamentally inconsistent with the major hurdles to customer adoption that xSP players must overcome and low market awareness for many of their offerings. Now that the days of investing in unsound business designs are over, industry players and investors need to ask themselves hard questions about the economics of these businesses (Figure 3 & Figure 4 ).

Figure 4 Summary of business  design archetypes
Business design/ archetype number	Sample  companies	Observations and outlooks
Applications reseller 1	Qwest Cyber.Solutions USinternetworking Corio Jamcracker	Some significant customer wins, but as a group have not lived up to initial market hype Basically a next-generation systems integration business
Software/ suite provider 2, 3	Centra Intralinks S1 Technologies Salesforce.com Intaz (Asia) Cassiopay (Europe) Peoplesoft Microsoft	Niche-focused software vendors exploited new application opportunities created by the Internet and advanced on numerous fronts As niche businesses will continue to multiply and thrive, integrated suite providers will bring potentially blockbuster products to market
Portal 4	Covisint TriZetto	The last couple of years saw hundreds of portals enter the market, but few created strategic control, and customers did not come as anticipated Still a good business concept, but only a few potential winners per vertical
E-process outsourcer 5	Exult Employease	Internet has facilitated e-outsourcing, especially in  HR/payroll/benefits space The group is a solid bet to expand both the depth and diversity of its offerings
Applications management services 6	IBM EYT Cap Gemini	Limited success managing complex, mission-critical applications in a network-centric model The group should benefit as customer comfort with the concept grows and as a tougher economic climate encourages companies to outsource applications
Web host/ infrastructure provider 7, 10	Exodus Digex Qwest AT&T IBM Global Services EDS	Aggressive data center buildouts and the dotcom implosion created significant overcapacity in hosting, pushing the viable players into managed services Major communications providers and IT outsourcers should collide as both move aggressively into the same managed infrastructure space
MSPs/ point infrastructure solutions 8, 9	Loudcloud ModelIN Groove Network	Most specialized best-of-breed” infrastructure providers have gathered far more press attention than market traction Specialized value propositions from recent start-ups should have limited appeal when set against broad managed infrastructure offerings from major incumbents
Source: Mercer

• Pure-play applications hosts need to study the early failures and ask: Is there a sustainable “total cost of ownership” arbitrage opportunity I can capture? If not, how do I create sustainable value for the customer while earning a reasonable return on my infrastructure and development investments?

• Communications providers must plan carefully before moving up the value stack. What is the impact of each new investment on current industry capacity, pricing and margins? What is the strategic intent of new competitors I will meet in these businesses? What consequent ROI and ROA scenarios might evolve? Where are the profit zones, the no-profit zones investments that are, in effect, loss leaders?

The value creation potential of the xSP revolution is real, but so are the risks. There are also risks in staying on the sidelines and not participating in the development of network-centric computing. The greatest risk of all, however, is playing in the xSP space without a winning business design.
John Hanson and David Sovie are senior partners of Mercer Management Consulting, Boston. Their respective e-mail addresses are john.hanson@mercermc.com and dave.sovie@mercermc.com. This article is based on a Mercer Management commentary called “The xSP Revolution, Round 2: Separating Winners from Losers,” which will be available in mid-September at mercermc.com.

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Value at the frontier

A fundamental barrier to the growth of the xSP model is that the software needed to bridge the business design gap between players simply does not exist. Most observers of the xSP space do not sufficiently understand or appreciate this challenge. But a new layer of middleware must be developed that allows for much more robust and scalable billing, security, provisioning, SLA monitoring, server partitioning and application management.

A key value creation issue is who will develop this new layer of middleware. Loudcloud, other managed service providers, and VC-backed middleware developers such as Ensim, Tarantella, and Groove Networks have made significant investments in developing such systems.

But the winners will likely come from among the 800-pound gorillas known as Microsoft, Sun Microsystems and IBM. The gorillas should see this frontier as a major growth opportunity and central to their future.

For example, Microsoft has made its .Net and Hailstorm initiatives top strategic priorities and is recruiting software vendors to write Web-ready applications. IBM is countering with its WebSphere product line, with extensive support from IBM Global Services. Meanwhile, Sun has its Sun Tone program.

The battle will be fascinating and take years to play out, so stay tuned.

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