Software Shakeout



When USinternetworking was launched in April, 1998, investors swarmed like
yellow jackets around a honeypot. The outfit was a new kind of company–dubbed
an application service provider–and it promised to transform the way software
had been used by corporations for more than 30 years.

Instead of selling customers large and complicated packages, USi would
provide them with instant access via the Web to the software packages from such
established software makers as PeopleSoft and SAP. No fuss, no muss. To venture
capitalists and Wall Street investors, it seemed like a blockbuster idea. They
bet nearly $500 million on the company.

Unfortunately, USi was almost as good at spending money as it was at raising
it. By last October, only $60 million was left and the company was burning
through a hair-raising $80 million a quarter. USi’s stock, which had once
topped $73 per share, had skidded into the single digits. The fate of the
company rested on winning a $50 million loan from General Electric Capital Services. It got it, along with $270
million in additional private financing from the likes of Microsoft.

USi lives, but its near-death experience is symptomatic of an entire industry
that popped up in its wake. Spurred on by analysts’ projections that the ASP
market would be worth more than $6 billion by the end of 2001, more than 500
companies were funded with a mind-numbing $10 billion in venture capital. The
analysts, as it turns out, were wildly wrong. Concerns about the security of
company secrets and the reliability of the Internet scared off many potential
customers. At the same time, the ASPs faced huge costs for building data centers
and licensing software packages from publishers. The result: Their money started
running out before revenues kicked in.

If this keeps up, the potential exists for techdom’s biggest belly flop
since the pen-computing fiasco of the early 1990s. The ASP market is expected to
drum up only $600 million in sales this year, according to IDC, less than 1% of
all information-technology spending–not nearly enough to support the horde of
competitors. Market researcher Gartner Group predicts that 60% will go under in the next year.

True believers

By all rights, the money tap should have shut down for ASPs. But it just
keeps flowing. That’s because some of the leaders in the first generation–including
USi–seem to be getting their acts together and a new generation of ASPs is
being born. Rather than buying packages from established software companies,
these new contestants are building software from the ground up to run on the
Web. That makes the services more efficient for them to run and easier for
customers to sign up for and use. In the fourth quarter of last year, well after
stocks of the few publicly traded ASPs had tanked along with the rest of the
tech industry, venture capitalists pumped $1 billion into these companies.
Crosspoint Venture Partners in December announced plans to invest $350 million
in new ASPs that target specific industries, from groceries to banks.

Indeed, plenty of people still believe that the wave of the future is
offering software as a service that’s delivered over the Web. Corporations
have been complaining for years about the expense and trouble of computing
systems. They have to pay millions of dollars for the gear, then pony up again
each year to maintain and update it. With application service providers handling
these tasks, they can concentrate on running their businesses–and simply pay
the ASP a monthly fee. Carey Eisenhower, Internet marketing manager for the
Hershey Direct Division of Hershey Foods, says he’s saving at least 20% per
year on software-management costs because he’s a customer of USi. There is an
added plus: “We didn’t have the expertise to build an e-commerce site.
USinternetworking did,’’ says Eisenhower.

In spite of the early glitches, the basic ASP concept is compelling for
software companies, too. Today, they depend on selling enough software packages
each quarter to meet Wall Street’s expectations. It’s not unlike the movie
business, where studios’ fortunes depend on at least one megahit a year,
creating spikes and valleys in their revenue streams. By delivering software as
a service, their revenues should be more predictable. And when new technology is
ready, it can be instantly included in the software and piped to the customer.
While the first round of market projections were way off, researchers still see
a sizable opportunity: IDC, for instance, estimates $7.3 billion in sales in
2004.

By Jim Kerstetter with Jay Greene in Seattle in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc

Looming battle

Those who like software dished up this way aren’t going on faith alone. One
company, VeriSign, shows that offering up software as a service can work
profitably. VeriSign, which sells encryption services for e-commerce sites and
corporate communications, posted $474.8 million in revenues last year, up 460%
from a year earlier. Pro forma net income hit $45.5 million. VeriSign is a
winner because it spotted a technology needed by every company doing business on
the Net, then beat others to the punch by offering it as a service.

That sets the stage for a bruising battle this year. With piddling revenue
streams to be had in the short run, the early ASPs will fight desperately to get
the formula right while next-generation companies pile into the market. And the
old behemoths? Don’t count them out. They, too, want a piece of the action.
“The software business is going to change fundamentally in the next three
to five years,” predicts Oracle chief executive Lawrence Ellison.
“Oracle is going to be ahead of that charge.”

Some of the pioneers now seem to be on the right track. USi has rounded up
170 customers, and its revenues grew 208% last year, to $109.5 million. Analysts
project revenues this year around $165 million, with the break-even point coming
in the third or fourth quarter. The best news is that USi has finished building
three huge data centers for running the software, which analysts say totaled
more than $300 million. Another leader, Corio, reported revenues of $43.6
million last year, up 650%. Analysts project $75 million in revenues this year
and profits early next year. Both companies are now asking customers to pay part
of the cost of software licenses up front. They have skirted problems
encountered by some of the ASPs that failed, such as Pandesic, which tried to
make money off of fees based on its customers’ e-commerce sales.

No matter how well they tune their engines, though, the first generation ASPs
will have a tough time outperforming the newer entrants. The newbies establish
one super-reliable Web site that all their customers hook into–plugging their
information into simple templates. They don’t have to buy a new set of server
computers for each individual customer, as the pioneers do. If the Young Turks
get it right, the economies of scale could produce gross profit margins topping
90%–dramatically better than the 70% average among traditional software makers
and the 15% to 20% margins that early ASPs have achieved, say analysts. Boasts
Marc Benioff, chairman of sales-force-automation ASP salesforce.com: “We
are going to kill traditional software.’’

Don’t think that big software companies will oblige Benioff. Microsoft, for
instance, is betting its future on an online-service strategy. In addition to
allowing ASPs to rent out such desktop applications as Word, Microsoft is
building a technology foundation upon which other companies can build their
services.

With a market as embryonic as this one, it’s too early to call winners. The
Microsoft of the ASP world might not even be alive yet. But, already, some of
the contestants are promising. Analysts especially like VeriSign’s prospects,
since it has a proven track record and a dominant 75% share of the market for
Internet encryption.

While the notion of software as a service could turn the traditional
packaged-software world upside down, the approach has deep roots in computing.
For decades, companies such as IBM have run other people’s software from their
data centers for a monthly fee. When the Internet came along, Web-hosting
companies managed sites for tens of thousands of companies. USi’s innovation
was to offer the full array of corporate applications–from accounting to
materials planning–as services delivered via the Web. IDC dubbed this an
application service provider.

For a while, the computing world was nuts about ASPs. At the height of the
mania, in the fourth quarter of 1999, venture capitalists pumped $2.5 billion
into these companies. That was half of all the money invested in new software
companies that quarter, according to McKenzie Consulting.

So what went wrong? The biggest obstacle has been inertia. It’s just plain
hard to persuade people to try something new. In interviews with more than 25
corporate customers, BusinessWeek found balky executives. Corporate IT
departments are reluctant to give up control over their computing systems. CEOs
are worried about Net security and fret about handing important business data
over to another company, though those fears have so far proven to be unfounded.

Missing link

For some, the numbers simply don’t add up. The ASPs claim they would have
been cheaper partly because they believe Abraham underestimates the cost of
building and operating fail-safe computing systems like the ones they provide.

When ASPs do manage to land customers, sometimes they fail to deliver the
goods. Even among customers who get satisfactory service, there’s a tendency
to move cautiously. At Hershey, for example, just one tiny portion of the
company, an e-commerce site called Hershey Direct, has gone online with an ASP.
The rest of the company’s computing systems are run through a separate
computing division that sticks to running software the old-fashioned way.

Now ASPs are reconciled to slower growth than they had first expected. That’s
why they’re focusing on profits. ‘’The market is much different than it
was a year ago,’’ says USi CEO Andrew Stern. To cut costs, USi laid off 11%
of its staff in January. Now it’s asking customers to pay at least 20% of the
total cost of a contract up front.

While USi and Corio are struggling to get on a winning track, they’ve got
to be wary of the next generation of ASPs who are coming up from behind. In
little more than a year, salesforce.com has landed 1,700 paying customers and
25,000 companies are participating in free tryouts. NetLedger.com, which
provides small-business accounting services, has 3,000 customers. It’s just a
very different proposition than the one USi and Corio face. Since these newbies
build their technology themselves, they don’t have to pay a software supplier
for programs.

It’s low-risk for customers, too. While second-generation ASPs don’t have
all the bells and whistles of a mature software program from PeopleSoft or SAP,
they make it very easy for customers to sign up and use the services. For
NetLedger’s service, the price is just $9.95 a month to start. A corporate
customer can add more users at any time, and they also can drop them.

Growing payroll

The biggest challenge for the new crop of ASPs will be attracting big
customers. NetLedger doesn’t even try. It’s meant for companies with less
than 100 employees. Salesforce is aiming higher, but so far its largest customer
has just 300 users of the service. Are these upstarts going to snatch away giant
business software projects? Not yet. "Maybe in a few years I would consider
working with them," says Nick Amin, vice-president of information systems
at Cigna in Philadelphia. "They don’t have all the capabilities that I’d
need at this point"–such as sophisticated risk-analysis tools.

That’s already starting to change. The upstarts are quickly adding such
features as sales forecasting. And their deals are getting bigger, too.
Employease, an Atlanta-based human-resources service, has seen its average
customer size increase from 96 employees to 441 employees during 2000. "I’m
supporting 500 people with Employease," says Reed Vickerman, vice-president
of information technology at Copper Mountain Networks in California.
"Adding more would just be a matter of clicking a button."

The software giants can’t turn on a dime like the upstarts, but they’re
quickly becoming forces to reckon with. The furthest along: Intuit, the $1
billion maker of financial and tax software for small businesses and consumers.
Already, Intuit is reaping more than 20% of its revenues from online services.
Every piece of packaged Intuit software, from the QuickBooks accounting program
to TurboTax, has an online counterpart.

While Intuit has the jump on its brethren, other major software makers vow to
excel at delivering their software as services. Software heavyweights such as
SAP, Oracle, and PeopleSoft have a distinct advantage over the first-generation
ASPs when it comes to profit margins. They don’t have to buy somebody else’s
software–they make it themselves. In the past year, Oracle doubled, to 100,
the number of customers using its finance, manufacturing, and customer-service
applications online. With SAP, 16 ASPs are hosting its applications for 150
customers.

Microsoft is going at this market a bit differently. While it offers its
Office desktop applications to customers through a handful of hosting services,
its main goal is to provide a software platform for corporations and ASPs to
build upon–the so-called .Net technology. As part of Microsoft’s $50 million investment in
USi last fall, the upstart agreed to offer customers services based on Microsoft’s
technology. But Microsoft faces stiff competition from Sun Microsystems and
Oracle, which also supply foundation technologies for Net services. Upstarts
such as salesforce.com and NetLedger built their systems on Sun’s heavy-duty
Unix operating system and use Oracle databases. Would they ever retool for
Microsoft? "No way," says NetLedger CEO Evan Goldberg. "We don’t
think Microsoft software is ready for an online service."

Making the transition from the traditional software business to services won’t
be a snap for the established giants. They’ve got to retool their technologies
to run smoothly on the Web. And they’ve got to tinker with their business
models without upsetting quarterly earnings–shifting from their dependency on
huge, up-front license payments to monthly fees.

Rather than mess with what’s working well, some of the established software
companies are opting out of the ASP business–at least, for the time being.
Consider Check Point Software Technologies, which sells firewall software that
protects corporations from intrusions by thieves or hackers. It’s deeply
committed to a network of 1,000 distributors that handled 90% of its $425
million in revenues last year. Offer services directly to customers?

Shwed, however, may be in the minority. Most established companies are
gung-ho for offering software services. "If software companies don’t do
this–maybe not today but somewhere down the line–they are going to
die," says Tim Chou, president of Oracle Business OnLine. That may be too
dire a prediction. However, given the volatility of the software business these
days, it makes sense for them to at least hedge their bets.

Jim Kerstetter with Jay Greene in Seattle–BusinessWeek

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