Summary:

This article appears in the June 1, 2001, issue of Red Herring magazine. At the height of the dot-com boom, one business was even more fashionable than the half-witted e-tailers: data centers. As venture capitalists pumped billions of dollars into e-commerce startups, those companies developed a […]

This article appears in the June 1, 2001, issue of Red Herring magazine.

At the height of the dot-com boom, one business was even more fashionable than the half-witted e-tailers: data centers. As venture capitalists pumped billions of dollars into e-commerce startups, those companies developed a sudden need for a place to outsource their servers and bandwidth. Exodus Communications (Nasdaq: EXDS), which had been a struggling ISP, jumped onto this bandwagon, and others like Equinix (Nasdaq: EQIX), Globix (Nasdaq: GBIX), and NaviSite (Nasdaq: NAVI) quickly followed suit. Data-center revenue boomed from $941 million in 1999 to $3.5 billion in 2000.

But now, as the industry faces a slowing economy and the demise of free-spending dot-com ventures, the party’s over. The recent entry of large telecommunications companies like AT&T (NYSE: T), Qwest Communications (NYSE: Q), and WorldCom (Nasdaq: WCOM) into this market is making the data-center business a price game that only the flush can play. Meanwhile, demand is shifting in favor of managed services provided by startups like Avasta, Intira, and Loudcloud (Nasdaq: LDCL).

Data centers, also called co-locaters, rent equipment, space, and bandwidth to companies that don’t want to host their own Web sites. Managed services companies take this concept one step further and maintain Internet infrastructure for large companies. While many data-center companies offer managed services, their primary revenue comes from co-location.

Data-center companies have drastically increased their capacity: by the end of 2003, their worldwide gross square footage will jump nearly ten times, to 83.6 million, and the number of data centers will grow tenfold, according to Tier 1 Research, a market research firm. But that growth has been funded by debt, and companies now are watching their cash reserves empty and their debt burdens increase.

DEBT CENTER For example, the San Francisco brokerage WR Hambrecht estimates that Exodus will have to shell out about $365 million, or 20 percent of estimated revenue, in interest expense on its $2.8 billion in long-term debt. In 2002, expect that number to hit $400 million, which means Exodus may have to raise more funds from the capital markets.

And the capacity brought by that debt may go unused. According to Tier 1, dot-coms represented a third of hosting revenue in 2000, and as startups go under, data-center companies’ business is drying up; Exodus, for example, recently lost two premier tenants, eToys and Pets.com. The company this past week said it would lay off 15 percent of its workforce in an effort to cut costs.

In the meantime, the data-center business has attracted deep-pocketed giants like AT&T, Qwest, and WorldCom that are bent on taking market share away from existing players. As those companies see some of their core businesses — like consumer long distance — wither, they are looking for new ways to derive revenue from their existing networks. Because companies like AT&T and Qwest own networks, they can afford to sell services at lower prices to attract customers — a luxury that data-center companies cannot afford. Besides, corporations are more likely to choose big players, not small companies, for their outsourcing, says Tier 1 founder Andrew Schroepfer. And while the outsourcing business retains its long-term appeal, at the moment corporations looking to cut IT spending are delaying plans to outsource infrastructure.

The telecommunications stalwarts are serious about using data centers to increase their flat-lining revenue streams. In 2000, both Qwest and UUNet (a division of WorldCom) nearly doubled the number of their data centers; by 2002, AT&T plans to have 44 data centers. Existing players that have mounds of debt to pay off will find it tough to play the price game.

Increasing cash reserves won’t be easy, given that data centers generate so few dollars per square foot. Tier 1 Research data shows that average annual revenue for pure co-location services is $216 per square foot. By comparison, Wal-Mart’s (NYSE: WMT) 376.5 million square feet in the United States generated $133 billion in 2000, or roughly $355 per square foot. Translation: Wal-Mart did much better by selling paper towels, soap, and other sundries than it could have by running a data center, which, theoretically, is a high-margin venture. Tier 1 estimates that a data center running at full capacity needs to generate $808 per square foot in its first year to break even.

On the other hand, managed-services companies, like Loudcloud and Avasta, can generate up to $2,500 per square foot. Ironically, those companies rent space from co-locaters, and since they have no overhead, they have a better business model. Even if data-center companies shifted their focus to managed services, it would be a few years before they could compete with existing players like IBM (NYSE: IBM) and EDS (NYSE: EDS).

“This is a challenging time to be in the co-location business, because the new players are telcos who have deep pockets,” says Greg Gore, an analyst at WR Hambrecht. “It is turning into a volume game, and the players with the deepest pockets will win.” Tier 1’s Mr. Schroepfer predicts a shakeout among the first-generation companies, followed by a period of consolidation. “Telcos were the fools a few years ago,” he says, “and now they have all the cash.” Already WorldCom has snapped up Digex (Nasdaq: DIGX), and a recent report speculated that Cable & Wireless (NYSE: CWP) may acquire Exodus.

At this rate, unless data centers quickly increase their reliance on managed services, formerly foolish telcos could sweep in and buy existing players for pennies on the dollar.

Write to om.malik@redherring.com.

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