VCs To Startups: Get Thee To The Cloud

Last week's Hosting and Cloud Transformation Summit (HCTS) brought together the gamut of data center services players and set them loose to mingle with equipment suppliers, customers, and, perhaps most interestingly, financiers. After two days of attending panels and talking with data center operators and industry analysts, it's clear that the hosting business is thriving while maturing and, yes, transforming.

One key trend: The big are getting bigger as the industry consolidates--witness last year's $3.2 billion CenturyLink-Savvis acquisition and $1.4 billion Verizon-Terremark deal. Everyone's rushing to stay ahead of cloud technology advances and scale infrastructure to meet IT demand. And we're not just talking megadeals. It's clear from both public presentations and my private meetings that the trend of small, regional players getting gobbled up by larger national companies will continue, and perhaps accelerate. One twist: Increasingly, the buyers are private equity firms looking to aggregate regional hosting providers, often those focusing on a particular geographic or vertical market niche, into larger, more diverse firms with a richer set of service offerings.

The bankers' ultimate goal is to spin these combined companies off as IPOs or dangle them as acquisition bait for even bigger fish. However, there are interesting implications for corporate IT.

As we stated when discussing massive new colocation centers like Las Vegas' own SuperNAP and in our recent State of the Data Center report, there's just no reason for many enterprises, particularly SMBs and government agencies, to own and operate data centers. HCTS showed that the barriers to outsourcing low-level IT operations are decreasing by the day. In fact, Kelly Morgan, senior equity analyst at 451 Research, says she's heard that Silicon Valley venture capitalists often require investment targets to live in the cloud, with no owned and operated infrastructure, or even applications, as one criteria for funding. VCs want their investment dollars going to product development, not infrastructure. That's a sentiment increasingly shared by CEOs and line-of-business managers, which is a good reason CIOs had better take note.

Today, the trick is figuring out just what type of service is the best fit. Taking a broad view, the hosting and cloud infrastructure market is stratified into four layers.

At the most basic level are wholesale providers like CoreSite, Digital Realty, and DuPont Fabros. The best analogy is a shopping mall operator that leases unfinished retail space in a large, multitenant facility that comes with professional design, management, and security. Morgan says this segment typically targets companies that need 10,000 square feet or more, with a few hundred racks. Wholesale providers give you floor space, power, cooling, and network taps, but little more; you're responsible for installing your own racks and cabling and managing your equipment.

Next up the value chain are retail data center providers, better known as colocation facilities. Morgan says these typically appeal to smaller customers (sub-10,000 square feet) that can fit their equipment into a few racks or a small server room cage. The value here is that all of the physical construction is done, racks and cabinets included, but you still run your own systems.

Pushing further up the stack are managed hosting providers. Rackspace, the poster child for this group, was first to migrate from selling floor space to server operations. MSPs not only provide Tier 1 data center space, they handle low-level server and storage system administration, freeing IT to focus on application and end user support. Rackspace garnered particular attention at the show since it's both the largest managed provider and, reportedly, the most profitable, though exact numbers are hard to quantify since many MSPs aren't publicly traded. In my meeting with Sean Wedige, the Rackspace CTO of global enterprise solutions uttered the phrase "fanatical support" early and often and cited customer service as key to Rackspace's success and future growth.

At the top of the infrastructure stack are pure infrastructure-as-a-service providers, led by 800-pound gorilla Amazon Web Services. AWS’s dominance is continually challenged by a steady stream of new cloud specialists, like SoftLayer, as well as by established services behemoths like EMC, Hewlett-Packard, Microsoft, and Verizon/Terremark.

While IaaS tends to get the most media attention--mainly because it fits the cloud zeitgeist--so far these providers typically are limited to filling niche enterprise application needs. They're less apt to be wholesale replacements for substantial pieces of the core infrastructure. Yet this is precisely the role IaaS plays in startups and small businesses, which often completely rely on cloud infrastructure and/or SaaS for their IT needs. They're all-in on the cloud and proudly so.

It's clear that a quest for higher profit margins is fueling the hosting industry's migration to higher-value services. From IT's standpoint, in return comes relief from facilities design and financing and the care and feeding of data center and server infrastructure. Convenience does come at a cost, however; operating your business on IaaS or SaaS may well be more expensive long term, as illustrated in a column from my colleague Art Wittmann regarding Amazon's failure to track steep reductions in storage system costs.

The numbers clearly depend heavily on sunk investments. However, as current facilities age, the decision point is, will you trade limited dollars for short-term opex rather than long-term capex? And will the competition I saw at the show result in an answer to Wittmann's challenge, like the one put forth here, or will consolidation limit the pricing battles that benefit IT?

The stance of the providers at HCTS was laid out in a logically impenetrable and data-rich keynote by Peter Hopper, CEO and co-founder of DH Capital, a private investment firm that specializes in Internet infrastructure, telecommunications, and SaaS. Hopper made a case that moving up the stack offers greater profit and healthier margins.

Enterprise IT teams need to keep a close eye on infrastructure providers. This is a vibrant, highly competitive market full of vendors and investors all angling for your business. Yes, there are technical, governance, security, and compliance challenges, but after spending a few days rubbing elbows with hosting providers, I have no doubt they well understand customer concerns and are working to address them. Your would-be competitors are shedding the overhead of data center maintenance--VCs are making sure of that. Look ahead a few years and make sure you're positioning your business to compete on an even field.