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Commentary: Facing the fiscal music

In Web-hosting or related fields these days, there is no shortage of companies announcing financial problems.

In Web-hosting or related fields these days, there is no shortage of companies announcing financial problems.

Just this week, Digital Island stated

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Net-speeding business falters
disastrous quarterly results--a net loss of $1.19 billion on revenue of $32.8 million--and Exodus Communications announced the departure of its CFO, COO and head of marketing and an easing of its push toward new data centers. Loudcloud announced layoffs this week, just about a month after Akamai Technologies said it would lay off some of its staff. Pilot Networks, which counted General Electric as a customer and investor, simply shut its doors with no announcement.

During the dot-com boom, two ideas drove these Web-hosting and ASPs (application service providers). The first was a "build it and they will come attitude"--everyone was going to need huge, complex Web sites to play in the "New Economy," and demand for Web hosting would grow exponentially. That turned out to be a wildly optimistic expectation.

Second, these companies expected that everyone would go to a model of renting software off servers on the Web rather than maintaining their own software. While that ASP model did prove appropriate for some niche markets, it did not work for the general marketplace.

Starting with those twin expectations, hosting companies adopted a strategy of buying market share at any cost, with the expectation that at some point demand would drive prices up to cover costs. They invested hugely in data centers and points of presence. Now they are trapped without enough business as companies pull back on their Internet plans. Many are still forced to charge less than their expenses to try to attract business to fill up empty server farms, and they show no prospects for paying off their debts.

Web hosters can be divided roughly into two groups--those that provide only Web hosting and those that also provide value-added services such as systems integration, middleware, and content delivery. The latter group also includes companies, such Genuity and IBM, that are taking advantage of their server farms to provide more traditional outsourcing along with Web hosting.

The first group is trapped in a commodity marketplace where the low-priced service wins--but goes out of business because it is losing money on each contract--while the higher-priced services make money only if they can attract customers despite their price disadvantages.

The second group can create a stronger business model by charging more for their value-added services, including customizing applications, systems integration, content delivery, sophisticated security and business-process consulting. These services also make it harder for clients to move to lower-cost providers, which cannot handle the complexities that go with them.

Where ASPs feel the bite
The ASP portion of the hosting market is facing similar rough times. The survivors in this group will be those that position themselves in niche markets where ASP deals make sense. Those providers depending on business from the general marketplace will be disappointed.

ASPs focusing on electronic procurement present good examples of all these issues. The most basic e-procurement ASPs offer racks of servers and storage along with network connections and basic operations capabilities. As are basic Web-hosting companies, this type of ASP is caught between relatively high costs and the inability to drive commensurate revenue.

The next tier up in e-procurement ASPs is more capable at the applications level, providing some customization and integration. These players look like many other ASPs and will need to beef up their capabilities quickly to avoid getting sucked into the commodity-pricing realities of the low-end marketplace.

At the top of this marketplace are sophisticated players that provide assistance in key e-procurement business processes such as strategic sourcing and vendor management, backing these capabilities with sophisticated application and integration expertise. This group has a good chance of succeeding, but will certainly not be low-cost providers.

In general, we expect many Web-hosting and ASP services to go out of business and sell their assets--mostly farms of servers and storage arrays. The probable buyers will be the large traditional outsourcers, such as Computer Sciences, Electronic Data Systems and IBM, most of which also offer Web hosting but at the high end of the price scale. Other probable buyers will be the telephone companies, particularly local incumbents, such as BellSouth, Qwest Communications International, SBC Communications and Verizon Communications, that have more money to spend than the debt-ridden long-distance companies.

You get what you pay for
As Web-hosting companies face the fiscal music, customers need to watch carefully for signs of financial weakness and should prepare contingency plans for moving to a new service should their current provider fail--which could occur without formal notice as in the case of Pilot Networks. Consumers should maintain a daily backup of their sites in case their host does shut down abruptly.

There is no reason to panic, but consumers should plan carefully and be ready to move quickly, as the mantra of the hosting marketplace shifts from "buy the cheapest service available" to "you get what you pay for."

Companies that depend on their hosting providers for middleware and software integration will need a more detailed contingency plan than those that merely outsource Web hosting. Switching costs are fairly low for buyers of basic hosting services. But consumers of advanced software administration services will need to be very careful about who they partner with.

Those with simple marketing sites will find switching to a new host fairly easy. If they can afford to risk having their site down for a day or two, they may want to shop on price, realizing that the low-priced hosting service will probably not survive but that they can take advantage of the temporary situation to save money.

Consumers with transaction-oriented sites that are an integral part of their businesses should look for a host with a strong business plan. These hosts will be more expensive, but they will be much less likely to cease operations and create a business emergency for consumers.

Meta Group analysts Jack Gold, David Yockelson, David Cearley, Val Sribar, Dale Kutnick, David Willis, Diana Harotian and William Zachmann contributed to this report.

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