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Web hosting: Survival of the fittest

This week's departure of two well-known names from the Web hosting business is the latest sign that only the strongest will survive in the rapidly consolidating market.

This week's departure of two well-known names from the Web hosting business is the latest sign that only the strongest will survive in the rapidly consolidating market.

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On Monday, Loudcloud, a 2-year-old company led by Netscape Communications co-founder Marc Andreessen, said it will sell its Web hosting business to services firm EDS for $63.5 million.

Then, on Wednesday, Intel said it was shuttering its Web hosting division, which had such Web heavyweight clients as eBay, and would take a charge of $100 million to exit the business.

Both companies said that while the Web hosting market looked rosy just a few years ago, the business is now much less promising. The reason? Fewer potential customers to offset the relatively high cost of running a hosting operation.

"I think these companies are looking at the costs involved, and the profit margins, and are saying to themselves, 'If you stay with the game for two to three years, will you have a good outcome?' And the answer they're coming up with is 'not likely,'" said Antonio Salerno, CEO of Santa Clara, Calif.-based Conxion, a privately held hosting firm that provides services for companies including Microsoft.

It's not that Web hosting isn't a viable business model, said Marc Jacobson, e-business analyst at technology research firm Ovum. It's just that it's a very expensive one.

"Web hosting is an incredibly capital-intensive business to be in," Jacobson said. "I don't think (this week's events) indicate that there's a major crises and no margins available. Companies like IBM and EDS that understand the margins very well--they're succeeding and making money off this business. But it's not for the faint of heart."

Even Intel--the world's largest chipmaker--wasn't willing to sink more money into Web hosting, an adjunct to its main semiconductor business. The company, which back in 1999 said it would spend $1 billion to grow its hosting operation, said current "market trends and financial projections for the hosting services industry" are too bleak to warrant further investment.

The somewhat low price EDS paid for Loudcloud's business "implies relatively low value for Web hosting," Morgan Stanley analyst W. Todd Scott said. "This valuation level implies that the Web hosting business is not as profitable or as high growth as we had hoped," Scott wrote in a research note.

The rich get richer
At a basic level, Web hosting firms run data centers to host and maintain the equipment and networks for Web sites. But many also offer other services, such as maintaining databases and application services.

Only a few years ago, in the midst of the Web's explosive growth, hosting companies were being told they couldn't build data centers fast enough. In 1999, Forrester Research was predicting the market would reach $14.6 billion by the end of 2003, up from the $2 billion in business done that year.

But the dot-com bust, coupled with a downturn in the broader economy, dried up much of the expected business, and start-up hosting firms, banking on a coming gold rush that never materialized, ran out of money.

What we're seeing now, said Forrester Research senior analyst Maribel Dolinov, is "a player shift."

"In the past six to 10 months, what we've been seeing is that the funding to help these businesses move on is simply not there. Heaven help you if you're a small (Web hosting) business and you're looking for money," she said.

Even well-known, relatively successful companies, such as Exodus Communications, couldn't survive the downturn. The company went bankrupt last year and was bought by British telecommunications firm Cable & Wireless.

Jacobson thinks the Web hosting business will continue to consolidate down to a few major players, including services companies like EDS, Accenture and IBM Global Services. Those companies see Web hosting as a profitable adjunct to their other information technology outsourcing operations. Since those firms long ago spent the millions of dollars necessary to build data centers, they can add Web hosting services at little incremental cost.

Jacobson and other analysts also see telecommunications firms--such as Cable & Wireless, Digex and others--moving more deeply into Web hosting as a way to wring additional revenue from their corporate customers. And there may still be room for smaller players--like Conxion--which can specialize on a particular market segment, said Jacobson.

Conxion's Salerno compares the existing Web hosting market to the car industry. "You have the top five (automakers), but you still have companies like Porsche. It's not for everybody but not everybody needs that," he said.

In Web hosting, "you'll have people at the very high end doing the Fortune 100, and people at the other end doing $19.95 dial-up hosting for consumers. And you'll have some companies in the middle, serving very specific needs," Salerno said.

Forrester now says the market will top out at $5.6 billion in sales this year and could reach as much as $30.8 billion in 2006--if current Web growth projections pan out.

"The business will move to fewer providers who have a larger share of the market," Dolinov said. "But is the market still growing? Sure."