In The News
SOURCE: Web Hosting Magazine

THE M&A SCENE: SURVIVAL STRATEGIES IN AN EVOLVING MARKET

By Dean Mann
Web Hosting Magazine
2002

We're well into the first quarter of 2002, earnings are coming out and the survivors in the hosting industry are rapidly rising to the surface. Now is a good time to catch up on recent activity within the industry, as we're a few months removed from 2001, a year of turmoil with a seemingly continuous stream of bad news. Have industry attitudes shifted over the past few months? What, if anything, are the money folks up to? And, most importantly, what does the future have in store for the hosting industry?

The primary theme over the past several months has been, and continues to be, balance sheet clean up. Everyone is really working on his housecleaning skills - the VC-sponsored maid service is long gone - and when given the opportunity, companies are looking for ways to restructure their balance sheets and get out from under too much debt for not enough revenues and growth. Of course, many didn't have that luxury - some waited too long or were just too far under water. But those that were able to pull something off may stand to gain ground as we enter the next generation of the hosting industry.

Weaker players are quickly being weeded out, some of which simply got caught up in the hype and pressure to grow at a rate that sprinted far ahead of demand. The quintessential example of this phenomenon is Exodus, which recently announced the closing (out of bankruptcy) of a large portion of its assets to Cable & Wireless. Exodus was unable to scamper away from the crushing debt above its head, sank into bankruptcy and C&W pounced on the opportunity to continue its aggressive hosting strategy. But a few public hosts are still treading water, hoping their restructuring deals will help position them to be survivors - or at least to attract well-healed suitors. NaviSite (Nasdaq: NAVI) and Globix (Nasdaq: GBIX) both made announcements regarding steps towards restructuring their respective balance sheets, albeit in different ways.

Drastic Measures
In early November 2001, NaviSite announced a restructuring deal between itself, Compaq Financial Services (NYSE: CPQ) and CMGI (Nasdaq: CMGI). (As of Oct. 31, CMGI beneficially owned 76 percent of NaviSite, and along with its affiliates represented 30 percent of NaviSite's revenue for the quarter ended Oct. 31.) As part of the deal, Compaq and CMGI injected approximately $30 million into NaviSite and restructured some of its operating leases. But realistically the deal put Compaq firmly in NaviSite's driver's seat. Compaq now holds $55 million in convertible notes that, if converted into common stock, would give it 71percent ownership of NaviSite assuming CMGI does not convert its notes. (If CMGI did convert, Compaq would have 63 percent ownership and CMGI would have 28 percent.) We don't have room to get into every detail from Navisite's 10Q filing, but the information it contains doesn't match up with the company's spin. NaviSite's revenues have been steadily declining while it continues to burn cash, and Compaq seems to be positioning itself to grab a piece of the hosting market with its funding. Most likely, the company most known for its PCs will end up owning Navisite.

Globix, meantime, has taken more meaningful steps to restructure, which required a pre-packaged Chapter 11 bankruptcy reorganization plan. Globix will emerge, subject to all the necessary approvals, a much leaner company with what it no doubt hopes is a more manageable debt load. The company reached agreement to exchange its $600 million of 12 percent senior notes due 2010 for $120 million in senior secured notes, due in 2008, with interest at 11 percent, payable in kind for up to four years. The agreement will give bond holders 85 percent of the common equity; Series A preferred holders will get 14 percent; and as usual, the existing common stockholders get the short end of the stick, left with only 1 percent of the equity and no dates. Globix reported that the deal will save the company $75 million in annual cash interest expense on the existing notes. The problem will center around whether $120 million in debt is too much for a company that is still burning significant amounts of cash and has reported declining revenues. Sometimes fixing the balance sheet is like replacing the tires on a car with serious engine problems - the real problem may be the business itself.

Data Return (formerly Nasdaq: DRTN), which provides hosting solutions based on the Microsoft platform and manages roughly 1,500 servers housed in data centers managed by Level 3 Communications, was facing a difficult situation itself, but was able to solve its problems, for the time being, through acquisition. In early January 2002, divine (Nasdaq: DVIN) closed its stock-for-stock acquisition of Data Return, which hitched its horse to the success of divine's consolidation strategy focused on providing enterprise solutions. Unfortunately for the Dallas-based web host, divine's stock has slipped approximately 33 percent since the deal closed, although still at a premium to when the deal was announced in November 2001.

Stronger players are seizing the opportunity to take advantage of this housecleaning phase, and no story about the hosting space can be written without mentioning the folks at Interland (Nasdaq: INLD). With $170 million in the bank, the company is positioned to drive a lot of the activity and direction inside the SME hosting space. Interland is wasting no time establishing itself as a buyer, recently striking deals to acquire AT&T's small business-focused shared and dedicated web hosting assets, the shared and unmanaged dedicated retail hosting business of Interliant (Nasdaq: INIT), and Kansas City, Mo.-based host CommuniTech.Net.

Out on the middle market front, Hurricane Electric, a business ISP focused on connectivity and hosting, recently announced it was acquiring Minneola, N.Y.-based Lightning Internet Services. The deal marks Hurricane Electric's move east; it had been strictly a west-coast player.

Adventures in Venture Capital
So what about the venture capital activity in the last six months? It seems fair to say that there are still a lot of investment dollars sitting on the sidelines. Venture capital funds are not planning on returning the money to their limited partners; they intend to put the money to work. And we believe the hosting space will see its share of investment attention.

We continue to see money going into the hosting market, albeit at a much slower and disciplined pace (and at lower valuations), which is not necessarily a bad thing, although it may be frustrating to the operator. Whether it is the hosting service providers or the companies providing the hardware and software to increase efficiencies and automate processes, hosting is still an interesting story. Of course, there is still a lot of work to be done with most of the original investments in the sector, and it appears most venture capitalists are still focused on addressing their current portfolios of companies. In some cases that means there are problems to fix; in others it's a situation of finding a stronger position in the market.

The recently announced CyberGate-Affinity merger highlights this scenario. First, Herndon, Va.-based e.spire's chief executive officer, George Schmitt, pulled the CyberGate (also known as ValueWeb) asset out of the e.spire (OTC Pinksheets: ESPIQ) bankruptcy for roughly $23 million, according to the press release. He then immediately announced a merger with Affinity. The new merged company, called Affinity, Inc., is headquartered in Fort Lauderdale, Fla. According to the press release, the combined company hosts more than 275,000 domains for approximately 100,000 customers worldwide. In the SME hosting space, size will matter. The bar is being raised, and a few providers are realizing it takes a new set of metrics to be ready to compete in the future.

To offer some context, Verio (which now sits inside of NTT) has at least $300 million in hosting revenues, and over $80 million in shared hosting. EarthLink (Nasdaq: ELNK), known more for being a dialup provider, reports nearly $54 million in annualized hosting revenues, and they're barely trying. Interland is most certainly over a $100 million annualized run rate given its recent spate of acquisitions. The bar is getting higher, and its getting there quickly.

To provide a little background, Affinity was created back in July 2000. It's a tale of three small hosting companies, a wizard and a powerful ring - oops, wrong story. Affinity came into existence when SkyNetWEB Ltd. of Baltimore and ProWebSite Hosting Corporation and Dynatek Info World Inc. d/b/a SiteHosting.net of City of Industry, Ca. merged with a simultaneous $60 million equity injection from JP Morgan Capital Corp., Columbia Capital, and First Union Capital Partners.

As an outsider to the deal, it seems to support the crazy notion that it's high time to look for ways to get bigger, sooner rather than later. I imagine the Affinity investor group is not the only set of VCs with hosting investments on the lookout for opportunities to better position their investments in the new market environment. Better positioning in the SME hosting space today must include the right management team, size, cash flow and one ring to rule them all! Sorry, keep going back to that. Let's look at a couple other deals.

TELUS Ventures, a subsidiary of TELUS Corporation (NYSE: TU) recently announced a $2 million investment in Hostopia, a provider of outsourced private-label Web hosting and an anchor tenant in TELUS' Toronto-based data center. TELUS also announced that it has incorporated Hostopia's hosting software solution as part of TELUS' Web-hosting package targeting the SME market. Back in October 2001, TELUS also put $2 million in Jamcracker, an enterprise web services company that provides access, management, integration and support for web-enabled applications. Along with the investment, TELUS also formed a partnership to offer Jamcracker services in Canada.

But analysis of the hosting space cannot be limited to the service providers. We need to examine the other pieces of the value chain to understand the dynamics of the hosting machine.

Sphera raised $5 million, part of an add-on investment to its $15 million second round that it completed in October 2001, from TLcom and Jerusalem Venture Partners. Sphera develops web hosting and management software, it's best known for its lead product, HostingDirector, which automates the management of web hosting operations.

In October 2001, BladeLogic raised $6 million in its first round from Battery Ventures and Bessemer Venture Partners. BladeLogic provides multi-platform technology to manage networks of servers running a variety of operating systems.

Most recently, PlateSpin raised $1.9 million. PlateSpin is a Toronto-based developer of server infrastructure management software. It is looking to assist companies - either enterprises or service providers - that are operating large server networks by improving operational efficiencies in managing software in distributed server networks. Automation is essential to the success of the SME hosting space, and without the proper software and processes it's a non-starter in the shared hosting space.

The Good Fight
At the end of the day, we believe in this space and many of its parts. But there's a lot of cleanup left to be done, and we've discussed what strategies the players are using to stay afloat. Smart marketing, acquisitions, and securing capital at a lower cost than competitors will win the day, provided there's enough mass to create the necessary momentum. Above all, keep your heads up!