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