Does ASP Mean Awesome Stock Prospects? [Fool on the Hill] July 18, 2000

FOOL ON THE HILL: An Investment Opinion
Does ASP Mean Awesome Stock Prospects?

Some researchers project the Application Service Provider (ASP) marketplace will explode to over $23 billion in 2003 from less than $1 billion in 1998. If this happens and companies like USInternetworking, Breakaway Solutions, or NaviSite gain a significant slice of the business, they could be worth much more than today's stock valuations.

By Warren Gump (TMF Gump)
July 18, 2000

The stock price drops in many technology stocks over the past few months has created an opportunity to invest in some companies with high-growth prospects at much lower valuations than was required in the early part of the year. Whenever such a situation occurs, I like to take a look at some of these stocks to see if anything piques my interest.

One emerging industry that has caught my eye is the application service provider (ASP) market, which provides outsourced software solutions to companies. These companies stock prices have fallen 60% - 80% since their peaks earlier in the year. While that doesn't mean they're a good value, I wanted to look into them a little further. Let me preface this article with the fact that I'm new to the industry. What attracted me is the excellent business logic behind using ASPs and a Gartner Group projection that the industry will grow to $23 billion in 2003 from less than $1 billion in 1998.

If you've ever been at a company implementing a major new software package like PeopleSoft or SAP, you're probably aware of the serious costs and energy associated with such an endeavor. In addition to paying megabucks for the software, a company also needs to buy lots of hardware and probably hire some more information technology (IT) professionals to support the package. And then there is the cost of hiring a consulting firm to customize and implement the package. All in all, the process can be enormously expensive, take a long time, and monopolize a company's technology resources.

ASP providers have emerged to help alleviate some of these problems. These companies lease software packages to customers and provide round-the-clock customer support. Such an arrangement saves the customer the upfront cash outlay for the software and the need to staff up their technology department with support people. In addition, some of the pain of implementation can be reduced because the ASP already has the core software up and running and has lots of experience with new deployments.

ASP contracts generate recurring revenues since most contracts last for several years and require customers to pay a fixed monthly fee. This means that the ASP provider has money coming in every month for the life of the contract. In addition to having these revenues, an incumbent ASP has opened the door to provide "add-on" packages if a customer decides to use an ASP for additional applications. The likelihood of getting contracts renewed is also higher than normal due to the significant switching costs.

The leading publicly traded ASP companies are USinternetworking (Nasdaq: USIX), Breakaway Solutions (Nasdaq: BWAY), NaviSite (Nasdaq: NAVI), Interliant (Nasdaq: INIT), and Corio (expected to come public this week under the symbol CRIO). Other people involved in the industry (or expected to enter) include firms like PriceWaterhouseCoopers and IBM Global Services, as well as the software companies themselves.

Being in an emerging industry, most of the companies are just developing their business models and investing for the future. All of the ones listed above are recording losses and have market capitalizations many times their current revenues. At the close of business yesterday, USinternetworking was worth more than $2.1 billion, 42x trailing 12-month revenues. Breakaway Solution's value was $1.3 billion (33x trailing revenue) and NaviSite was worth $2.6 billion (more than 65x revenues).

While those price/revenues figures are high, these statistics are pretty meaningless right now. Since this business is in its infancy and growth should be tremendous, these companies need to be valued on reasonable expectations about what they'll achieve over the next few years.

At the beginning of the article, I mentioned that the Gartner Group expected the ASP marketplace to grow to $23 billion over the next couple of years. If a leading player could grab 10%-15% of that, it would have revenues of $2.3 - $3.5 billion. Assuming net margins of 10% (I've seen projections of 15% - 20%+ for some), the company would have net income of $230 - $350 million.

Assigning a fairly conservative (it's still in the midst of rapid growth) 25x earnings multiple on this company results in a $5.8 - $8.8 billion market value three years out. Discounting this back to the present at 30% a year yields a current value of $2.6 - $4.0 billion -- a range higher than the values of the three companies mentioned above.

Most likely none of the things I've assumed above will happen. The ASP market is not going to be exactly $23 billion. The leading company probably won't have a 10%-15% market share with 10% net margins and won't have a 25x earnings multiple. Nonetheless, combining all of these guesses together gives me a guesstimate of what such a company could be worth. While the Gartner estimate of potential market size seems somewhat aggressive, all of the other variables strike me as being fairly conservative -- providing the possibility for positive surprises.

The ASP industry has numerous risks that could cause it to not develop as anticipated. Software developers could decide to invade the market themselves and try to squeeze out the independent ASPs. A security lapse at one company could cause other firms to become more skeptical about outsourcing integral applications. An influx of competitors could drive profitability well below expectations. Or something else could hamper industry growth.

All that said, the industry seems to have some tremendous growth opportunities. If you can find a company that's poised to be an industry leader in a few years, the stock price spiral over the past few months could provide the long-term investor with an attractive entry point.

Your Turn:
TMF Gump isn't smart enough to know who the ASP industry leaders will be three years out. Can you share your knowledge of individual companies and the industry to help the Fool community figure out who the possible leaders will be? If so, come on over to the Fool on the Hill discussion board.

Next Step:

  • Application Service Providers, Stock Research Feature, 6/22/00
  • USInternetworking CEO Christopher McCleary, Stocktalk 12/6/99
  • Breakaway Solutions Discussion Board
  • Interliant Discussion Board
  • NaviSite Discussion Board
  • USInternetworking Discussion Board