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Will hosting boost or bruise software makers?

Software makers say the coming wave of business application hosting services will create a new market for their products, but some are warning that hosted services could also cut into revenues.

Software makers say the coming wave of business application hosting services will create a new market for their products. But some software companies and industry analysts are warning that hosted services could also cut into revenues and affect their business models.

Traditional packaged software companies--including Oracle, SAP, Baan, PeopleSoft, and others--should expect to take an initial hit in revenues as they make the switch to the new hosting model and begin offering their software through application service providers, said analysts.

The move to offering hosted applications is "a very risky transition for traditional software vendors," said Clare Gillan, an analyst with International Data Corporation. "The problem is if [a software maker] starts to become an application service provider it will change the revenue stream having some possible negative impacts initially. It may hit them in the short term, but level out as time goes on."

Application hosting via an application service provider can potentially save companies money by offloading all responsibility for software updates, user management, and server maintenance onto a third party.

What's unclear is how the new hosted model will impact software sales in the long run. Software companies say application service providers are simply a new distribution channel for their products and will add customers to their base. However, some analysts reason that if the model catches on, the potential market for buyers of business software could shrink as companies opt to rent software via hosting services rather than buy or lease the software themselves. That could cause software maker revenues to drop, since software users will pay less. And even though software application service providers will still need to license software from makers, they represent a smaller overall market for software products since there are fewer of them.

Software makers are hedging their bets. Most have some sort of hosting plan, but few seem to know how the new model will affect their bottom lines. Oracle, for instance, in its annual report, states that while distribution of its business applications through application service providers "may provide a new market" for its products, the new distribution method "could also reduce the price paid for the company's products or adversely affect other sales" of its products.

Business software, such as enterprise resource planning packages from Oracle, SAP, PeopleSoft, and other companies, have traditionally been licensed as a product directly to companies. Software licensing costs are typically hundreds of thousands of dollars, plus yearly maintenance fees. Usually, responsibility for the hardware and upkeep of the applications rests with the company that licensed them, adding additional costs .

The new application service provider model, just beginning to take shape, will make those same applications available as a service through a third-party hosting firm for a monthly fee. Oracle has jumped into the application hosting business with both feet. The company's hosting option, Oracle Business OnLine, is intended to be an outsourcing service for small and medium-sized businesses that do not, or cannot, handle their computing needs in-house. The service will offer hosting of business applications based on Oracle's Applications software, plus hosting of third-party applications built atop the company's database software.

Software companies, at least officially, claim that the application service provider model will help them to reach smaller companies that may not have been able to afford their software in the past. If smaller companies do begin to move to hosted services, the application service provider model could also represent a much-needed new revenue stream for software makers.

However, if larger companies come to the same conclusion, and opt for hosted services instead of direct licensing, revenues could take a hit as software companies lease fewer copies of their applications in favor of lower-margin hosting services. Software makers typically maintain gross margins in the 85 percent to 90 percent range, estimates Todd Weller, an analyst with financial services firm Legg Mason. Hosting services will return gross margins of 45 percent to 50 percent, he estimates.

Whether or not hosting will cut into software makers' revenues "depends on the software company," said Weller. "If a traditional license software company changes its whole strategy, they could see a haircut in their revenue line."

Right now software companies on the whole appear to be putting forth models that protect their revenue streams, said Gillan.

For example, German software giant SAP and Oracle competitor in the enterprise software market both consider their application service provider program just a small part of their overall product strategy.

Unlike Oracle, SAP has an application service provider program based on a string of partnerships announced over the past year. In August, the company announced that Cupertino, California-based eOnline will manage and host SAP's complete suite of enterprise resource planning software for customers.

In May, SAP announced an outsourcing deal with telecommunications company Qwest in which both companies said they would promote SAP's flagship R/3 business software to smaller companies in that industry. As reported, Qwest said it will manage and support SAP software running on Hewlett-Packard computers through its data centers.

"We look at it as incremental, not something to replace what we already have," said Ted Weniger, vice president of sales for the services sector at SAP.

But this may change, Gillan said. As more and more start-ups begin hosting their software from day one, traditional software companies will be forced to make the shift. "It's going in that direction," he said.

IDC doesn't necessarily see the shift to a hosted model cutting into software makers' revenues. Hosted services could mean a larger customer base for software companies. And, investors panicking over initial cuts in revenue should realize that the revenue stream should become more reliable and predictable with time, IDC says.

Of course, to realize any benefits from the new hosted world, software makers have to rework their existing models. According to a recent study by Boston-based Summit Strategies, failure to act soon on key issues such as brand consistency, pricing, packaging and partnership models could mean some software makers will be left in the dust by Web-centric companies offering a new generation of solutions designed specifically for Web-hosted delivery.

The difficult challenge these software companies face is changing from a product-centric model to the service-centric model required by the Internet, the report concluded.