The Fall Of Exodus

When Exodus Communications (NASDAQ: EXDS) filed for Chapter 11 bankruptcy protection on September 26th (see Exodus Succumbs to Chapter 11) it begged the question whether the concept of Internet hosting services on a large scale was ever a viable long-term business strategy.

Of course, it’s easy to have 20-20 vision in hindsight: The truth is that little more than a year ago few people questioned Exodus’ business model, and there were plenty of people willing to pay more than $62 per Exodus share, valuing the company at more than $30 billion. When shares were suspended last month at 17 cents, the company was valued by the market at a mere $85 million.

A Line from the Book of Exodus
The Exodus story on what went wrong is that the company grew too fast, assuming the Internet boom would last forever. “We sacrificed profitability in exchange for growth and market share, overexpanding in some areas in advance of demand, not anticipating the decline as the dot.com bubble burst and the economy weakened,” William Krause, Exodus chairman and CEO, said when announcing the Chapter 11 filing.

It’s certainly true that the dot-com boom presented a terrific opportunity for companies such as Exodus to expand, (the company acquired Web hoster GlobalCenter for $6.5 billion paid for in stock) but the attendant risk that the bubble would burst was always present but was neither recognized nor prepared for.

The real problem for Exodus is that the large-scale hosting services it specializes in are effectively the only string to its bow. Contrast this with competitors in the hosting sector such as AT&T, Qwest or BT. These companies are large network providers with many other revenue sources — for them, hosting is a nice additional service to provide when there is demand for it.

The crucial point is that hosting accounts for only a tiny part of these large carriers’ revenues, and less than 10 percent of participants total revenues across the hosting industry, according to analyst IDC. So while Exodus has filed for Chapter 11, these carriers and other companies with alternative revenue sources are still around to pick up any customers who may decide jump from the Exodus ship.

What Could Have Been ….
Given Exodus’ strategy of concentrating on the hosting market, and of trying to be a big, rather than a niche, player, is there anything more it could have done to avoid its present predicament? Perhaps, according to James Eibisch, research director at IDC in the UK. “Exodus should have moved quicker from providing co-lo services to more profitable managed services,” he told ASPnews. “Profit margins on managed services are two or three times more than you are likely to get from co-lo,” Eibisch said.

Effectively co-location service has become a commodity, and the only way to make significant profits from a commodity service with narrow margins is by offering them on a grand scale. But arguably Exodus lacked many of the advantages that the large telcos who also offer co-location services on a grand scale enjoy — existing customer bases and their own networks, for example. And when you try and trade in large volumes on small and diminishing margins, you become vulnerable to a downturn, as any PC vendor will tell you.

Summit Strategies analyst Amy Levy agrees that the market changed much more quickly than Exodus evolved to address those changes. “Rack and stack is not what it was five years ago. Exodus was definitely a pioneer, but their time has come,” she told ASPnews. Levy said the likely demise of Exodus is a combination of evolutionary change, the collapse of the dot.com market and the company’s late move to managed services. However, she said is the company is likely to get “snapped up, probably by a telco, for their customers not for their space.” Exodus has 42 data centers in North America, Europe, Asia Pacific and Japan.

Exit Exodus?
So does Exodus have a future? Exodus stresses that it is in the process of “reorganizing,” not going out of business, and that many well-known companies such as Toys ‘R’ Us and Macy’s have reorganized and emerged successfully from Chapter 11. The key difference, though, is that Exodus is the supplier of a service that is of crucial importance to the financial well-being of its customers. In the case of mass retailers, it makes little difference to customers whether the toy store they buy a Barbie doll from is still around tomorrow. However, entrusting your company’s vital Internet operations to a hoster with a large question mark hanging over it is another matter entirely.

Exodus’ future will to a large extent be dictated by the confidence it can inspire in its customer base. If a few lose confidence, a trickle of defections could turn into a torrent.

While Exodus spokeswoman Melissa Newmann declined to say whether or not customers have begun defecting yet, that risk is clear and real. “Many customers as part of prudent business planning are evaluating contingency plans to mitigate risk,” she told ASPnews.

Exodus claims its customers have been supportive of the company since the Chapter 11 announcement, and this is borne out by customers such as UK-based ASP Aspective, which runs its operations out of an Exodus data centre in London. “We are continuing to use Exodus to host our ASP contracts as we believe that Chapter 11 status will enable Exodus to restructure the organization in a protected financial environment,” Richard Beniston, Aspective’s marketing director, told ASPnews. Contingency plans are in place to enable Aspective to move its operations to another data center should that become necessary, however.

Despite Exodus’ upbeat messages, the truth is that the company is now unmistakably a takeover target. Rather than reorganization and a return to business as normal, it’s quite likely that Exodus will be acquired by someone in a related business with a strong financial position. If this happens most of its data centers would probably survive along with its service offerings, even if the Exodus name disappears. But hosting would almost certainly not account for a very significant part of the new owner’s total revenues. It does not seem that that would be a viable business strategy at all.