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Which ASPs Will Prosper Long-Term — and Why?

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The ASP industry is maturing at a record pace. John Harney discusses possible consolidation, mergers, and acquisitions; and why certain players in the resulting ecosystem look especially well-positioned for success.
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The Application Service Provider (ASP) industry is almost three years old now, and it is experiencing the growing pains of every new IT market. Most readers are familiar with other technology sectors that struggled slowly through their inevitable growth phases. Remember Apple's Newton, the first big name personal digital assistant? Poor handwriting recognition and other flaws rendered it a flop. Remember the early days of wireless, when you couldn't send an e-mail more than a few words long over a distance more than a few miles? Capacity and distance limitations plagued it for years. Today, cell phones and PDAs are ubiquitous for mobile professionals and many laymen. But those developments took a decade or more. Many of these companies are just now becoming profitable and building stock valuation. What's more, many had to redefine themselves several times along the way by focusing on new vertical markets or teaming with other vendors whose technology complemented their original tools for a more powerful solution.

The ASP market differs from these markets in several critical ways, which suggest that it will mature and prosper much faster. First of all, the press—and many ASPs—made such unrealistically exaggerated claims when they came on the scene in 2000 that it was impossible for companies run by mere mortals to live up to them. Of course, when some ASPs failed to meet impossible expectations, there was an understandable—but equally hyperbolic—press backlash in 2001. Having inflated the marketing balloon to many times its realistic capacity, the press was shocked when it exploded.

Second, ASPs debuted about the same time the recession started. Their tenure as new businesses has paralleled almost exactly the duration of a bad economy. Given the fact that ASPs' target customer base was small-to-medium-size businesses (SMBs), you have to ask yourself the following question: How many SMBs will risk investing in a new business and technology model when the economy is thwarting their attempts to gain new business or upsell current business? Yet many did.

Third, every technology market evolves by means of vendor diversification and consolidation. Young technology markets typically experience a maturation dynamic distinguished by several overlapping phases—a launch and IPO/acquisition debut, followed by marketwide vendor proliferation, segmentation, consolidation, and stratification. This is the real crux of the issue for the ASP market.

The Industry Maturation Dynamic

Typically, new industries are kicked off by "disruptive" technology breakthroughs that outmode old IT paradigms. The Web browser, for instance, jumpstarted the Internet for lay users. Later, Virtual Private Networks and other value-added broadband networks ignited e-commerce for companies. The new markets that result often attract lots of IT speculators—almost always more than the new market can support. That's because new markets, though they are high-risk, are also high growth. Because all of these high-rolling entrepreneurs cannot be successful, however, not all of the companies they create survive even their various rounds of VC funding. Those that do, of course, can continue on course, go public, or get acquired by other companies.

But right from the start, some companies opt for acquisition as their hoped-for exit strategy. Instead of risking post-IPO devaluation, these entrepreneurs build companies for the express purpose of selling them to larger companies instead of going public. They make a nice trade-off with large companies with deep pockets—their new technology and limited cash flow for mainstream market adoption and financial security. Large telecom vendors such as Cisco actually built a business model based on rapidly acquiring companies with promising technology instead of building it themselves. In the IT industry, in which technology changes so fast, often "innovation through acquisition" is a safer and faster method of staying competitive than internal R&D is.

Eventually, however, this proliferation of new companies stabilizes, and the market begins to segment. Dominant players emerge in different segments (for example, in vertical markets or at the high or low ends of those markets). Smaller companies may specialize, and larger ones may focus on broader markets with products with wider appeal. It doesn't take too long to discern which companies will soon run out of capital or market share. This is when the number of companies stops expanding.

The next phase is characterized by consolidation. Successful companies acquire the less-successful ones that still have a promising technology or customer base; the less-successful companies merge to combine capital, market share, and customers. During consolidation, unless a company is very large (and doesn't need acquisitions) or very specialized (and doesn't fit into a larger company's strategic product/market portfolio), they eat or get eaten.

In the last phase, markets stratify. The dominant two or three vendors control the bulk of market share (80 percent or so), and many smaller vendors subsist on their percentage of what's left. Sometimes called "the walking dead," these smaller companies are not valuable enough to be acquired by the dominant players, but are too moribund to bring in big profits.

As the market gradually goes mainstream, those dominant and stable vendors win more customers and bigger customers than all the little players that existed in earlier phases. So the number of dominant vendors is fewer, but they generate greater revenues for the market as a whole because many big, conservative, deep-pocketed customers don't commit to a new technology until the market reaches this phase. From then on, vendors make evolutionary changes to their product lines to milk the growing market as long as they can—until the next disruptive technology breakthrough starts the cycle over again in a new market.

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