ASPs Say They're Ready to Strike but Show Meager Profits

Some onlookers wonder if heady projections are too optimistic.
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SAN FRANCISCO -- When Mike Abbaei, senior vice president and CIO at

Legg Mason

(LM) - Get Report

, looked at setting up the company's retail brokerage subsidiary

Legg Mason Wood Walker

last year, he quickly came to appreciate firsthand some of the costs of jumping into e-commerce.

Setting up shop online is easier said than done -- e-businesses require a new set of applications, including those that keep tabs on customers and allow customers to place their own orders. Another set of costs have to do with new applications needing to be integrated with earlier-installed systems and making sure they work round the clock.

Instead of embarking on what could have been an extremely expensive and technical venture, Abbaei picked application service provider

USinternetworking

(USIX)

to do the heavy lifting.

Application service providers, or ASPs, are the hottest

software

buzzword right now. Basically, ASPs host and maintain software for companies for a fee, allowing the companies to use very expensive software without having to pay large up-front licensing and implementation fees. For medium- to small-sized companies that don't have technology expertise, ASPs can significantly reduce the amount of money a company spends to maintain its in-house IT systems.

Proponents say ASPs allow companies to download applications over the Internet, with minimal customization and fewer in-house IT people to oversee the software. This can be a great help with back-office automation software, which costs millions of dollars and can take years to install and employ.

Software companies like

Oracle

(ORCL) - Get Report

and

Siebel

(SEBL)

have each laid down stakes in the ASP market. Oracle is offering to host its applications online on its own servers while Siebel has taken about a 3.25% stake in USinternetworking. USinternetworking is probably the most well-known ASP after its hot IPO in April in which shares soared as high as $60 from the IPO price of $21.

But if things sometimes sound too good to be true, they probably are. Though the idea of ASPs revolutionizing how software is leased through and distributed over the Internet sounds like a no-brainer, some fund managers are skeptical.

"Conceptually, it could be the next big thing, but what worries me most is the business model," says Michael Hahn, a fund manager at

Merrill Lynch

. ASPs have extremely high start-up costs in setting up data centers, and they have to pay for software licenses up-front but can only recognize revenue over time.

Take Annapolis, Md.-based USinternetworking as a case study. Hahn, who owns some shares of it in his personal portfolio, notes that the company's cash flows continue to fall deeper into negative territory.

USinternetworking lost $23.6 million, or 66 cents per share for the second-quarter earnings, although revenue rose 52% from the first quarter to $6.7 million. Cash flow or earnings before interest, taxes, depreciation and amortization were a negative $15.4 million.

Credit Suisse First Boston

analyst Mark Wolfenberger, who also noted the increasing operating losses, maintains a buy rating on the stock because he believes "the investment in USinternetworking is a play on the huge ASP market opportunity, not on short-term operating profits." First Boston was the lead underwriter in Usinternetworking IPO in April.

Just how "huge" is that market potential? The definitions vary among experts and leading market researchers.

Forrester Research

predicts the ASP market to hit $10.1 billion by 2001, while a less bullish

IDC

, forecasts the market to grow to $2 billion by 2003 from about $200 million now.

The demand for the hosting services is further clouded because many companies involved in the ASP market have yet to produce a long list of live customers. For example, Redwood Shores, Calif.-based Oracle spent a day outlining its ASP strategy to the press. Oracle claims 20 customers but only four are using the company's ASP offerings so far.

The ASP business doesn't generate much revenue for Oracle. Not that it concerns Mark Jarvis, vice president of marketing. "We only have four

active customers, but that doesn't matter right now because the

potential

number of customers is enormous."

In addition to hosting its own applications online, Oracle recently announced a suite of products to help Internet service providers, or ISPs, become ASPs and software developers make their programs Internet-based instead of client-server based.

Jarvis boldly claims that Oracle's ASP business could make up about 50% of Oracle's overall revenue within five years. For fiscal year 1999 Oracle reported revenue of $8.8 billion. "Net access is going to eventually be free, so ISPs will have to find another way to make money," he says. "One way to do that is to offer more services, and one of those services will be to host applications."

Siebel, which makes front-office automation software and is increasingly competing with Oracle, has also put a bet on the ASP market via its stake in USinternetworking. But CEO Tom Siebel believes the ASP market is "more hype than reality," according to a San Francisco-based analyst. The analyst, who declined to be named, says "everyone has to have a stake -- just in case," but Siebel believes the ASP market will be limited because "information is critical. Do you really want to outsource that? I wouldn't. I'd rather have my in-house IT staff to handle any problems." No one at Siebel was available to comment on those remarks.

USinternetworking vice president of marketing Michele Perry admits many companies have yet to be sold on the idea of outsourcing information. However, she's convinced that once ASPs get the initial burst of successful customers, the market will ramp up quickly.

Sure, but will USinternetworking still be around to see the ASP market take off?

"Sure, they can get the cash they need now with another round of financing because the market's good, but what happens if the market goes down?" says Merrill Lynch's Hahn. He says he will continue to hold his USinternetworking shares for now in hopes of striking some gold but is still nervous. Shares of USinternetworking fell 7/8 to 18 13/16 Tuesday.