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Best Web Hosting: Why Should We Be Concerned With The Evolution Of The Web Hosting Industry

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Why Should We Be Concerned With The Evolution Of The Web Hosting Industry

Monday, May 15, 2006
The evolution of industries contains four basic stages: introduction, growth, mature and decline. There has been considerable research done on the subject, but rarely do we see written material specifically addressing the stages as they apply to a specific industry. I would like to briefly look at the web hosting industry, trying to identify the value drivers and how they change, the signs of change from one stage to another, and each stakeholder's interest and how their value changes from stage to stage. In addition, I will make several comparisons to industries in the telecommunications world, because of the similarities in the business model, value drivers and stages of evolution. Most telecommunications industries and the web hosting industry grow under the recurring revenue business model: "Sell it once and collect until it churns". The evolution of industries occurs at different rates for different reasons. Attempting to quantify the future change in each of the value drivers is the science. Why should we be concerned with the evolution of the industry we work in? The answer depends on which stakeholder group you are in: employees; equity owners (passive or active); debt holders (bank, bond or preferred); senior or middle management (different implications for each); family; communities; equipment supplier, service supplier, customers, or a government agency. The value to each of these stakeholders changes over time through the evolution. It is important to note some industries evolve from the creation of a new technology such as paging, cellular, PCS, Internet access and web hosting, while others evolve from deregulation such as long distance, power suppliers and the CLEC (competitive local exchange carrier).

There are fascinating aspects of the web hosting industry which will dictate its future. First is the up-sell potential. Web hosting is experiencing an incredible phenomenon, which is the recurring revenue per client per month is still increasing after the introductory stage for the higher end managed hosting. No one knows how many services and applications we can attach to a corporation's web site. So, we can alter the aforementioned quote to read, "Sell it once, up-sell it and collect until it churns". Sure, other industries up-sell their customers, but nothing like this. This is a major difference from other recurring revenue businesses, such as cellular and long distance where prices started high then immediately started their linear journey downward. As far as the effect of the up-selling aspect of managed web hosting services, if the average monthly price continues much longer, much more supply will come to the market and possibly increase the magnitude of the commodity effect later on.

The second fascinating aspect is the portable nature of a web hosting business. As we all know, the (rookie) end user has no idea where the web site is hosted, neither should he care as far as geographic location. He should, however, care what country the host's servers reside in for obvious reasons. The portable nature of the web hosting business will be a key force in the mergers and acquisition phase of the evolution. For example, let's look at the post acquisition integration aspects of the ISP, paging and cellular industries. The customers, systems equipment, and the sales staff have to remain in the market (MSA), but customer service calls and the accounting and management teams can be moved to the corporate office. Note, there will still be considerable investment in the selling company's market. This has been the case with many industry roll-up scenarios. One of the major criterions in a company's acquisition strategy is the geographic location it wishes to be in. For the most part, web hosting doesn't experience nearly as much of the geographic restriction.

Value Drivers: First a quick note, due to the lack of time in this article, I will refrain from distinguishing between the hierarchies in the web hosting world: managed and shared. It should also be noted that both are viable strategies. A value driver is a measure used to track financial and operational variables in a business or an industry. The strength by which each value driver steers an industry varies from industry to industry.

1. Churn and Net Gains- Churn is simply the number of accounts that leave a company each month. It is a function of price elasticity, the level of customer service, the quality of the targeted customer base, the company's credit and collection policies, the number of competitors and their strengths, and the service/application offering. This number increases for all companies as an industry evolves through to the mature stage as the growth of the total market itself slows down. Net gains are achieved when the number of new accounts added for the month is greater than churn. This number turns negative in the decline stage (the paging industry). You can imagine the immense pressure that increasing churn and falling prices can have on increasing sales.

2. Average revenue per account per billing- This is a fascinating number, one that Wall Street is following quite closely because it speaks of the up-selling ability of the industry. Since this is a new industry, no one really knows how far this can go. Applications and services are being developed every day that will be added to web sites. The more advanced and specialized a managed hosting account, the less new capacity should affect prices and churn.

3. Revenue/EBITDA per sq. ft. of data center space- This addresses the efficiency of asset utilization. Presently, the data center build out mode in underway.

4. Market Size and Market Share- Market size is widely followed and certainly marks the different stages of the evolutionary cycle. When a telecommunications or technology industry slows to below 15-20 percent, most of the big returns have already been realized. It is usually past the maximum valuation of a private company. Regarding market share, the fight for this number can be the death of companies in the mature stage. How long will some companies sell services below cost to get it? In the paging industry, companies drove prices down below cost for so long, it left most of the public companies free cash flow negative for the entire life of the industry.

5. Expense Contributions- These numbers, measured in dollar amounts or as a percent, usually shrink as economies of scale are realized. These are great numbers to follow, especially as they pass the point of inflection.

6. Point of inflection- This is the point at which a revenue measure number is still increasing but at a decreasing rate or the converse, an expense contribution number is decreasing but at a decreasing rate. Depending upon the variable being charted, the point of inflection can occur at any stage of evolution.

7. WACC- The weighted average cost of capital is important to track over time once you back out the effect of the change in interest rates in the general environment of the market. It can illustrate the riskiness of an industry.

8. Capital Expenditures- All systems based telecommunications and technology companies have capital expenditures, heavy in the introduction and growth stages. This is an important number because it is usually the largest number below EBITDA to get to free cash flow. Sometimes in the late mature stage this number will rise again as companies invest in the next growth area. It is important to note that if free cash flow was not attained before the company invest in the new area, the company actually did not make any money in the first area of investment, regardless what the EPS figures show.

9. EBITDA Amount and Margin- These two numbers are very important for tracking the progress of telecommunications and technology companies because of the tremendous amount of capital expenditures and mergers and acquisitions (purchase method) that can distort the EPS figure. One of the greatest milestones in a business is reaching breakeven EBITDA (before adjustments). EBITDA margin tracks the efficiency of an operation as it realizes economies of scale. It usually increases as companies moves from introduction to growth. A major change in the evolution of an industry occurs when, after years of increasing the EBITDA margin, it starts to fall due to both pricing pressure and the lack of expense contributions, which at this stage are far past the point of inflection!

10. Free Cash Flow- At the end of the day this is the most important number to equity investors. It is the real amount of cash generated after all outflows of cash are accounted for. The end of the "beloved" pro-forma should include free cash flow.

Stages of Evolution
1. Introductory:
Signs:
- Consumers are being educated
- There are many engineering and systems standards with frequent changes
- Few sales channels
- Best period to increase market share
- Few competitors
- High prices and margins
- Price elasticity is low
- Venture capitalist, angel investors and Wall Street get involved; banks are too scared at this point

Comments:
The introductory stage is where venture capitalists come in and Wall Street focuses its attention. Venture capital groups play a crucial and necessary part in the evolutionary process. At this stage both the risks and the rewards are high, and capital for these projects is hard to find. At the end of the introduction stage, public companies start to make their appearance. During this stage, different engineering, sales, operational and financial strategies are attempted; some will prove to be viable others detrimental. Also, new products, services and applications will be developed. A big risk to the early players is that a superior technology can come to market after a company is already too heavily invested in the old technology to back out.

2. Growth: The Web Hosting industry is presently in this stage. Signs:
- Increased industry capacity
- Wall Street is heavily involved selling equity and raising debt; IPO's are common.
- The number of sales channels increases
- The greatest number of competitors
- Merger and acquisition activity is at its highest
- Larger risks are taken because plentiful capital and tremendous growth negates some risk
- Profits and sales growth are at their highest point
- Prices come down for comparable services
- Innovation is still present-
- The size of the total market is still growing
- In late growth, mergers and acquisitions in the vertical integration arena start to pop up as companies attempt to gain advantages in either cost/control over supply, or through distribution, (web hosting companies buying backbone providers or the other way around)

Comments:
While it may seem counter-intuitive, the mid to later half growth stage is the best time for a private company to sell. While there is still considerable venture capital activity directed toward the higher end technologies, the basic service companies have probably attained maximum value. Private market values are at the highest and there is plenty of Wall Street capital for public and private roll-up companies to do deals. The risk to the private company owner wishing to sell is that when the party is over, it ends quickly. Mergers and acquisitions can come to a screeching halt after the public companies stock prices get cut in half. When innovation slows down and supply is abundant, the industry will evolve into the mature stage.

3. Mature:
Signs:
- Mass market saturation (Dell, Intel, Micron and IBM become household names in the web hosting arena (ISP's)
- Little product differentiation (ISP's, long distance, paging)
- Few changes in technology standards
- Customer churn increases
- Price elasticity is high (long distance, a gallon of gas, ISP)
- Lower profits and margins, EBITDA margins turn back down, terrible sign
- Number of merger and acquisitions decreases, a few larger deals (ISP's)
- Public companies start to miss wall street numbers

Comments:
The commodity effect is the most feared of all signs in an industry. The mature stage is where there is little, if any, difference between service provider's offerings, and customers demand most or all of the services and applications included in the basic rate. The service offering is extremely price elastic. The relentless fight for market share at any cost by the large players in conjunction with a slow down in the growth of the total market is a sure sign of the end to the mature stage.

4. Decline:
Signs:
- Oversupply
- Unsustainable prices
- Churn overtakes customer adds
- Bankruptcies are common
- Wall Street has left the industry
- Mergers and acquisitions have come to a slow crawl

Comments:
Usually the only stakeholders that benefit during the decline stage are the employees and management that remain after the restructuring. The biggest losers are the debt holders (we assume the stock has already tanked). The ratings on debt usually start to fall. It is a fascinating phenomenon to watch as a recurring revenue company faces bankruptcy. When a furniture store goes bankrupt, they have a going out of business sale, sell all of the furniture, fire the employees and the owner of the building leases it to someone else, then the process starts all over. However, in the recurring revenue business, there is a recurring stream of revenue coming in every month. It benefits no one to turn the power off and cancel all of the cash coming in. So what usually happens is the debt is restructured and swapped for equity to take debt service payment pressure off the company.

Two final notes:
The following two present day scenarios show that the mature stage of an industry can last for decades. In addition industries can move back to a previous stage due to technological innovation.

Long Distance:
Several groups are predicting the demise of the consumer long distance business, which AT&T, Sprint, and World Comm dominate. The other side of the argument is that even if technology allows phone calls to be made over the Internet (after latency issues are worked out), the traffic will still be carried over someone's fiber network. The owners of the fiber network, many of the long distance carriers, will in turn bill for it. So the recent trend from circuit-based traffic to packet-based traffic will have a somewhat negating effect.

Cable:Just when we think we have figured out that an industry is in a mature stage, we get hit with what happened to the cable industry. Technological advances reversed the industry back to mid growth. The technology was originally intended for home television use. Now cable has become the mega-bandwidth pipe capable of delivering home telephone service, always-on Internet access, data transfer, long distance, hundreds of video channels and whatever else can be sent through the pipe. Now cable system owners are looking at receiving several times the original $30 per month for basic cable. Sure, there is additional capital required for upgrading each end of the pipe, but the basic infrastructure and the all important "right of way" (ask the long haul fiber optic people) are already in place.

Conclusion:
There are winners and losers throughout the entire evolution of an industry. It is important to know how it effects you, whether you are a corporate manager trying to guess the future stability of an industry, an entrepreneur wanting to know the best time to sell your business, or a product or service supplier trying to quantify future demand of its products. There are not many sure things, every path has its risk and return characteristics, all we have is history to guide us throughout our business world.

M. Eric Furlow, President
Furlow Consulting Corporation
362 Gulf Breeze Pky., #202
Gulf Breeze, FL 32561
http://www.furlowconsulting.com

Presently, Eric Furlow assists individuals and corporations both acquire, merge, divest and value technology companies. He has experience in over 150 transactions in the paging, SMR, cellular, tower, local phone, long distance, software, ASP, MSP, ISP and web hosting industries. He has a Masters in Finance from Bentley Graduate School of Business in Waltham, MA. Before heading up Furlow Consulting Corporation, he was the Mergers and Acquisition Manager for A+ Network, Inc. which was sold to Metrocall Inc. in 1996.

Article Source: http://EzineArticles.com/?expert=Eric_Furlow
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