More Deals, Funding Ahead for the Hosting Industry

The hosting industry's sustained growth has grabbed the attention of Wall Street, which has steered clear of the sector in recent years. That interest is likely to spur a fresh round of financings and deals, according to investment bankers.

"Investment dollars are definitely looking to go to work in the hosting space," said Peter Hopper, president of DH Capital LLC, a New York-based investment firm specializing in the hosting sector. "This is very different from a couple of years ago. The capital is starting to flow back in. There's no question about that."

Hopper spoke at Monday at HostingCon.2005, a two-day event which drew nearly 600 hosting professionals to the Hyatt Regency O'Hare in Chicago. Hopper noted that investor sentiment on hosting had been shaped by the bankruptcies of the dot-com boom years. "That view is beginning to change," said Hopper. "There are a lot of private companies that are getting huge and knocking the cover off the ball." That improved outlook is likely to mean more mergers and acquisitions, and an improved environment for hosting companies seeking to raise funding through private investment or even public stock offerings.

Much of the activity has focused on shared hosting, the most mature segment of the hosing business, according to Hillary Stiff, an investment banker with Cheval Capital, who addressed a packed room in a Tuesday session on the M&A outlook. "About 95 percent of the deals, large or small, are being done by providers who will consolidate your business into theirs. They're not going to be keeping your offices or service people or data centers. Migration is the biggest area of focus on these deals."

"In all of the deals we've done to date, we've migrated the seller's customers to our platform," said Joe Bardenheier IV of Endurance International Group, which has completed 25 shared hosting acquisitions in the past three years. The Boston company's brands include Hypermart, FreeYellow.com and FatCow.com, which it acquired this year.

Investors are being more cautious about the dedicated server market, despite furious growth in that sector in the past two years. "(Dedicated hosting) is the most interesting market, from a mergers and acquisitions standpoint," said Hopper. "There's this big mismatch between seller expectations and what buyers are willing to pay.

"There's been a lot of price competition, and if you're still growing, (dedicated servers) can be a capital-intensive business," he said. "We think the fact that growing dedicated hosting companies aren't generating free cash flow is one reason they're having trouble getting valuations."

While activity has increased, deals are getting done at lower prices. Hosting deals tend to be priced on a provider's annual revenues rather than profits, as an acquirer may not be interested in infrastructure and liabilities that affect a seller's financial performance. Stiff said shared hosting companies used to sell for 2.5 to 7 times their annual revenues in 1999-2000 are now being sold for a multiple of 0.75 to 1.25 times revenues.

"Multiples have continued to trend downward, and I really don't think they will rebound," said Stiff. "There's a number of factors depressing this industry. We're seeing higher churn rates, and downward pressure on pricing. The other thing about this industry is that there's no barrier to entry. For every hosting firm that sells or goes out of business, we see two taking its place."

Stiff primarily represents acquirers, who benefit from low valuations. Hopper was more upbeat about valuations, particularly for managed hosting companies, which focus on selling advanced hosting services to enterprise companies. The trend of businesses outsourcing their IT infrastructure is "in the early innings," said Hopper, and offers the promise of lengthy customer relationships and high-margin services. "These are very sticky customers," Hopper said of managed hosting. "These customers don't leave."

As a result, investors and acquirers place a high valuation on managed hosting providers. Last year Sungard acquired managed hosting firm Inflow for about 2.5 times annual earnings. Sungard was subsequently sold in a leveraged buyout to a consortium of investment firms in a deal that valued Sungard at more than $11 billion.

Netcraft's monthly Hosting Provider Switching Analysis and Hosting Provider Server Count provide details on the growth, competitive position and web-facing infrastructure of major hosting companies, including which providers are gaining market share, and from whom.