MSPs in transition

Managed service providers are evolving to meet customer demands, but in a market poised for a shakeout, you'd better pick your partners carefully.
Written by Max Smetannikov, Contributor

Within this story, you'll find these pages:
  1. MSPs in transition
  2. Look Ma, no data center
  3. What's next for SiteSmith?
  4. Coradiant's pitch: 'You outsourced too much'
  5. MSPs face hard questions about software
  6. Customer opportunity lost as Xuma collapses
  7. Old enterprise dogs learn new MSP tricks

It's no surprise that the crisis slowly engulfing managed service providers is barely evident. MSPs lack the cachet of dot-coms and the sex appeal of massive telecom construction projects. But the hundred or so companies that crowd the space today are expected to merge, go bankrupt or be snapped up by wealthier players interested in developing managed services expertise. They may be working to untangle data center operations from providing services, or they may branch out from a straight-out professional services model to include a colocation play. But all will transition from supporting only plain flavors of Web hosting to include more complex enterprise applications.

All this morphing may be for naught. Executives and analysts alike say that by 2003 only a handful of freestanding MSPs will remain.

There have already been casualties: Xuma flopped spectacularly, and AppGenesys, eManage, Intira and Logictier have all gone belly-up. Observers say the remaining players had to have launched by 1999 and needed about $200 million in capital to maintain a meaningful market share today. Potential buyers for the rest of the crowd include old-line systems integrators like Accenture and EDS, service providers like WorldCom and Web hosters like Exodus Communications.

This looming consolidation is the seamy underbelly of the MSP crisis. For every MSP that goes under or merges, there's a business pledging to never again trust its mission-critical processes to a startup. What will follow is a crisis of trust between corporate America and new outsourcers that will result in a flight back to the safe haven of familiar brands, established relationships and 20th century technology.

This special report will help I-managers distinguish the subtle differences in how MSPs handle the delivery and management of network-based services, applications and equipment, and how they are evolving to meet customer demands. One hint: Pick your partners as if you were getting married again.

Loudcloud is betting that the future of outsourcing lies in separating the business of running data centers from the business of supplying services.

So far, that stance has led to increased competition with its data center partners, such as Exodus Communications, and to unexpected support from active competitors, such as WorldCom's Digex. As MSPs and Web hosters go through a painful period of consolidation, Loudcloud's leadership is counting on this business model to win the hearts and minds of enterprise customers, because there are big challenges associated with developing new managed services.

"They [Exodus] have proven that it is tough to run both data center and MSP businesses simultaneously," says Ben Horowitz, Loudcloud's CEO and co-founder, referring to widespread criticism of Exodus' efforts to make more money selling managed services. "We colocate at Exodus, currently. They do compete with us. But I'd say competition - as we consider whether to stay with Exodus or to move elsewhere for more space - is less of a factor than some of the other issues surrounding Exodus. Viability is a concern, [and] there are some technical concerns that we have." Exodus stock traded near $70 per share a year ago; today it is trading in the $1 range. Three of Exodus' 10 board members resigned last month. CEO Ellen Hancock has repeatedly said she will entertain purchase offers.

Loudcloud's business is brilliantly simple: Loudcloud leases space from AT&T, Equinix and Exodus, and then resells it with its own managed services to customers looking for a one-stop Web hosting and management solution. As large providers of hosting services, such as Exodus, seek to extract more revenue from their enterprise customers, they begin competing with MSPs colocated within their own data centers.

While Loudcloud's Horowitz says his company never had any issues with colocation providers turned managed service vendors or with Exodus in particular, other MSPs, such as SiteSmith, did. SiteSmith executives say they expect to get the boot from Exodus because SiteSmith is an unwanted competitor.

Operators of carrier-neutral data centers, such as Equinix, also report increased activity by MSP competitors that let customers pay for hosting directly to Equinix, and then manage customers' server farms via cross-connects furnished by Equinix. These players differ from Loudcloud because they don't resell colocation space, and are capable of provisioning existing colocation customers faster.

"We see more MSPs successful in being mobile," says Jay Adelson, Equinix's founder and chief technology officer.

Loudcloud is unfazed by these challenges. Competition coming from colocation players developing managed services is expected to be weak, Horowitz says, since developing expertise at managing Web servers, databases, scaling server farms and so on is both time-consuming and expensive. There is competition from hosters such as Digex that have advanced managed services expertise, but it is still avoidable because Digex isn't as focused, he claims. Loudcloud invests heavily to maintain its differentiation, employing 100 people that write support for its Opsware software. Opsware automates as many tasks as possible, allowing the company to manage many sites with few people.

"We are pretty pleased to compete with people who are not in this thing full time," Horowitz says. "It's pretty easy to differentiate under such circumstances."

As far as MSP competition goes, Horowitz believes it runs to the other extreme of being too narrowly focused. "I don't think customers want to be buying monitoring from one company and database administration with security from the other company. This is getting into a level of complexity where you might do it yourself," he says.

So far, Loudcloud is a money-losing operation, reporting a first-quarter loss of $60.3 million on revenue of $11.7 million, compared with a loss of $14.6 million on revenue of $86,000 in the same quarter a year ago. But a new five-year co-marketing agreement with Qwest Communications is expected to boost revenues some, as Loudcloud moves the majority of its new customers to Qwest's hosting facilities.

Surprisingly, managed hosters, including Digex, embrace Loudcloud's business model in principle.

Digex pioneered managed hosting before players such as Loudcloud found a way to sell managed services without owning data centers. Now that WorldCom's acquisition of Digex is complete, the top brass plans to eventually surrender all ownership of data center facilities to WorldCom on the condition that data centers where Digex is colocated are designed to Digex's specs. And with all other factors being equal, Digex expects to beat Loudcloud - and any other MSP - at its own game, because Digex's managed service experience runs deep.

"We have been building out such capabilities since 1996, before Marc Andreessen knew these kinds of businesses existed," says Bobby Patrick, Digex's vice president of strategy and business development.

SiteSmith's new managed service pitch is fiber.

Now that its $1.36 billion merger with Metromedia Fiber Network has closed, the MSP that used a billboard facing an important, data-center rich Sunnyvale exit on U.S. Highway 101 in Silicon Valley to promise corporate customers it would build sites that "kick ass," is now a grown up corporate citizen.

MFN is the first facilities-based service provider to acquire an MSP. While the specifics of the plan -- beyond the obvious pitch to boost colocation revenue with managed services -- were fuzzy at the time of acquisition, now everything is crystal clear: MFN plans to leverage SiteSmith to knock out IBM and Electronic Data Systems in the competition for Fortune 1000 customers.

"The fundamental change of SiteSmith becoming a part of Metromedia Fiber was the move from us being an hourly-based professional services company to being a single source, flat-fee outsourcer for larger organizations," says Richard Dym, MFN vice president of marketing, who formerly held that post at SiteSmith.

Analysts tracking the MSP evolution say MFN is the first in what may be a long line of service providers combining colocation and network management with Web site integration and maintenance. Tier 1 Research President Andrew Schoepfer calls this new business model an "eCOLOsystem," and believes that new outsourcers like MFN have a leg up on old-school players like IBM. So for customers, it comes down to choosing between better technology and a trustworthy brand.

"The real issue in the market right now is flight to safety," Schoepfer says. "Customers don't want to worry about selecting a provider knowing that IBM or EDS will be there tomorrow.

"MFN has a great fiber network, and their facilities, on average, will be better than your average telco."

So in the fight for Fortune 1000 and Global 2000 business, the likes of MFN have an advantage because they are bidding now for large outsourcing contracts that Schoepfer expects will be spread around among a number of providers in 2002. The contenders are divided into two camps. In one pack are the new outsourcers, which include eCOLOsystems like MFN, integrated service providers such as WorldCom and large hosters with managed offerings, like Exodus. In the other are the old-style players, including consultancies like Accenture and system integrators like IBM and EDS.

MFN's Dym is optimistic his company will get a piece of this business. MFN already sells services to enterprise customers that buy its fiber.

"If we have fiber into the corporate data center, we are going to make our managed services available also," he says. "Our advantage is fiber, it lets us compete with the EDSes and IBMs in the corporate data center world."

The new competitive stance increasingly pits MFN against former SiteSmith allies like Exodus. Historically, MSPs leased space in data centers to avoid building out their own facilities. SiteSmith's well-documented rift with Exodus is rooted in Exodus' move into managed services and the company's desire to take that business away from SiteSmith. But MFN still has colocation leases with Exodus, which, Dym says, hangs on to every piece of business and thus tolerates them.

As SiteSmith begins to run with the big boys, the former MSP is also going through some corporate cultural changes. The dress code now has a more formal, East Coast feel and some of the perks that set SiteSmith apart -- like 4 p.m. beer hour -- are being reconsidered.

"We still do have beer taps [in our Silicon Valley offices], though I wouldn't be surprised if they go away," Dym says. "Insurance companies do not encourage that kind of activity, no matter how responsible you are about it."

Born out of the Canadian infrastructure consultancy Networkshop, Coradiant is one of the few freestanding managed service providers that seem to have weathered the dot-com fallout. The company makes the MSP business model work in part by steering away from unreasonable New Economy business risks like fast expansion and large lines of credit to customers. Coradiant remains unprofitable, but after receiving $20 million from Doll Capital Management, Grandbanks Capital and Sandlot Capital, CEO Alistair Croll says black ink is only a mezzanine loan away. Croll recently spoke with Senior Writer Max Smetannikov.

Q: Seems like not all MSPs will survive the recession.

A: I get a call a week about potential combinations. Philosophically, there were a number of MSPs that were built on New Economy assumptions. So if you were a dot-com, what you wanted the most was to get up and running next week, and money was no object, because your venture capitalists were telling you: "The sooner you get up and running, the sooner we can do an IPO, the sooner you can drive a Ferrari." I think a lot of business plans were built on that.

Q: So are MSPs a New Economy phenomenon?

A: The idea of an MSP is a sound one. There is a set of tasks that need to be accomplished, that lend themselves very well to economies of scale and skill. [But] some companies got reckless and were essentially hiring contract employees and not having control over what those employees did, and they were paying accordingly. We have a customer who was paying $67,000 a month for three servers before they hired us. That company was getting 20,000 hits a month - that's $3 a hit! You know what? If somebody wants to pay me this kind of money, I can build a business on that. But this is ludicrous. Those kinds of dollars don't exist. So anybody who has built an MSP business on numbers like that is doomed.

Q: How is Coradiant different?

A: There are a number of newer New Economy MSPs - and I'd like to think Coradiant is one of them - who have taken a harder look at this. Outsourcing has been around forever, like with payroll systems. That business model is still very sound. What we are seeing now is a lot of internal resistance, because the internal IT staff get worried when they hear the word "MSP." Our strongest selling point is: "Did you outsource too much?"

Q: Why would that be a problem?

A: Many people who have outsourced everything are now finding that their MSP is going belly-up or their data center is no longer letting them in, and are desperate to take back control. But they can't take back the whole thing because that is economically unsound. So how do you take back some control? The answer is, you outsource a lot more selectively and strategically than you have in the past. That's really the change we are seeing: The guys who are one-stop shops are floundering, and the guys who focused on a specific piece of the puzzle are doing quite well.

Managed service providers with software-hungry enterprises in their sites face a tough decision: partner with the big software vendors or compete against them.

Some say the future is in entering the software business and taking on the big vendors such as BMC Software, Concord Communications, Hewlett-Packard and IBM. But other MSPs are positioning themselves as partners, aiding software-on-demand schemes as application service providers did before them.

"Personally speaking, we have not heard about migration of MSPs into software business," says Todd Clayton, TriActive's vice president of marketing and president of the 112-member MSP Association.

Most MSPs' expertise lies in supplying a mechanism to implement a new business process, Clayton says, so most are behaving as conduits, delivering software as a service in partnership with the big vendors.

"There are some large companies that we are in discussions with - Intel would be one of them - that continue to receive requests from customers to be able to deliver what they are doing from a software perspective in an appliance model," says Robert Klotz, SilverBack Technologies' co-founder and vice president of business development. "We look at this delivery mechanism that we created as a way to revolutionize the way software is created."

Although the number of MSPs evolving into software vendors is growing, the number of MSPs joining with established software vendors to compete against their former cohorts is growing faster.

But how much differentiation can an MSP offer when all it has at its core are business processes and off-the-shelf software? The truth is that if an MSP has intellectual property that is unique, it should be able to go head-to-head with the like of BMC and win, says Paul Santinelli, founder and president of NOCpulse.

That's a risky theory, but NOCpulse is making it work. About 18 months ago, the nascent company exited the MSP business to become a software vendor, selling monitoring and reporting tools. NOCpulse recently beat out IBM's Tivoli Systems and BMC's Patrol for a lucrative contract with Sprint's E-Services unit - proof that its intellectual property is worth something.

"There are a ton of managed service providers all trying to carve one little niche, so there is no business to be had," Santinelli says. "You are either everything or nothing, and to be everything, you have to have raised $200 [million] or $300 million in capital by September 2000."

Other executives who are just testing the post-MSP software waters - including Metapa CEO Scott Yara - agree that hitting the $200 million mark was necessary to gain the market share to weather the current chaos.

Metapa, which launched as an MSP aiding companies with streaming technologies, is in the process of repositioning itself as a vendor. The company plans to make a splash this month, unveiling new software and services, and explaining its new business plan.

"I think this is the reality: The MSP business model would work only for the largest MSPs, like Totality," Yara says.

The greater responsibility that managed service providers take on - and charge top dollar for - backfires tenfold on those customers that have to live through an MSP default.

The highest-profile collapse has been Xuma, named by its flamboyant CEO Joe Cha for an ancient Chinese war cry that means "charging horse." The company launched four years ago from Cha's apartment in San Francisco's trendy South of Market district and quickly gathered $48 million from high-profile investors such as Broadview Capital Partners, Dell Computer, ING Capital and Menlo Ventures.

But in June, Xuma sacked 125 employees and closed its doors, leaving customers such as Arcade Planet, Cannon Computer Systems, CornerHardware.com, FringeGolf, Maxim, More.com and NextMonet in the lurch.

For some, an alliance with Xuma translated into untold lost opportunities.

Xuma built a gaming site for Arcade Planet that did not scale and had to be redone, which delayed its launch. "We were four to five months late because of Xuma. And who knows, maybe we could have gotten in on the IPO window before it and venture money shut down," says Bryan Kelly, Arcade Planet's vice president of engineering. "They grabbed too many projects, tried to make too many things happen all at once, and they hurt other companies because of that."

But before Xuma wreaked havoc with its own customers instead of its competitors, the company seemed to develop just like any other MSP.

Cha started Xuma in 1997 after stints at Anderson Consulting and PricewaterhouseCoopers. His chief technology officer and co-founder was fellow Anderson consultant Jamie Lerner. At the core of the business was monitoring and provisioning software, akin to the packages that most MSPs have, by now, either purchased or developed themselves.

Neither Cha nor Lerner, nor any Xuma board member contacted for this story would agree to an interview.

Xuma's first big alliance was a provisioning deal with PricewaterhouseCoopers. Marquee customers Pacific Gas and Electric and Cannon Computer Systems soon followed. But like Arcade Planet, few seemed to stay for long.

Technology not to blame

It was not the technology that killed Xuma - it was its management.

"Delivery dates slipped because they were always shifting staff around," Arcade Planet's Kelly says. The very shortage of qualified IT people that companies such as Xuma was supposed to relieve for its customers was eating the startup alive.

The gee-whiz software at the core didn't help much in curbing the body count, since standardizing on any kind of automation software would have limited the company to customers willing to abandon their existing systems in favor of something developed by Xuma.

By the time management realized the full ramifications of the situation, a competitor with tight control over costs and enough management star power to draw customers had popped up - Marc Andreessen's Loudcloud.

Xuma's Cha went on a media crusade, trying to poke holes in Loudcloud's story of innovation and noting that the competitor's name is "a white porous mass making loud noises."

But customers weren't buying the rap.

Xuma's programmers were top-notch and its tools excellent, but Kelly says it was tough to work with the MSP to dynamically update Arcade Planet's site. Add to that the trouble of getting into the cage whenever Arcade Planet wanted to make a gear change and Xuma's never-ending programmer turnover; within six months, the gaming site was bringing monitoring and maintenance in house.

The customers spinning through the revolving door finally caught the attention of investors. Cha left the company early this year. But by then, Xuma's attempt to grab a significant share of the managed services market was pretty much botched. As Loudcloud was adding customers such as Ford Motor, Xuma was shuttered, leaving behind more than 50 customers with no transition plan and no further guidance.

Managed service providers that focused on enterprise customers from day one feel confident as they watch their cohorts run through a quick and painful dot-com-to-enterprise-customer conversion.

The time and money spent three years ago learning to help large companies run complex back-office applications such as Enterprise Resource Planning (ERP) gives them plenty of lead to trump competitors that dawdled over understanding Web site maintenance, the hard-core enterprise MSPs say.

And indeed, they have managed to attract network personnel from companies such as Electronic Data Systems and Nasdaq, and are the only MSPs that have managed to get funding during the "nuclear winter" of the first half of this year. InteQ raised $57 million in May, in a second round of financing led by Merrill Lynch & Co. affiliates. SevenSpace gathered $45 million in February, also in a second round of financing. Some MSPs are already fully funded through scheduled profitability -- as Totality is, to the tune of $122 million. Investors are confident enough to fund these companies in a rapidly shrinking sector, because these MSPs are in a business that is rapidly expanding and are trading on their track records and, in some cases, unique expertise. In a sense, these MSPs are filling in the blanks for larger consulting and services integration companies, including Accenture and EDS.

"We go all the way from the network to the application layer," says Sharmila Shahani, Totality's vice president of marketing and business development. "We are not talking to any Internet plays, so all of the systems we are managing are very complex on the back end, with the e-business aspect being the simpler piece. The security and legacy ERP integration makes it complex."

Shahani should know: Totality integrated American Airlines' online reservation function with its massive ticket reservation system, Saber. Totality touts its ability to go into a corporate data center as a big advantage, since most companies are hesitant to move their mission-critical applications into third-party installations. Many Totality engineers come from EDS.

Part of Totality's solution is a custom-built monitoring and management software system that allows companies to outsource and insource certain corporate applications. Competitor SevenSpace says a custom build is an unnecessary expense.

"The tools we are using are familiar to enterprise IT," says Bill Phelps, SevenSpace's senior vice president. That, he says, goes a long way toward establishing a relationship of trust with corporate IT and easing back-end integration.

SevenSpace employs numerous former Nasdaq networking division workers.

The big challenge in the enterprise MSP space is channel relationships. The last thing businesses going the outsourced route want is finger-pointing by data center owners, MSPs and network operators in the event something goes wrong.

"Our customers are asking: 'Who is going to take accountability?'" Phelps says. To avoid conflicts of interests, SevenSpace partners with Web hosting companies to offer their services in a bundle, and works through escalation scenarios so that customer calls get to the right people on the first try. Totality also did a large scale partnership with a large Web hoster Conxion recently.

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