Web Hosts Merge To Become Cloud Players

by: Dana Blankenhorn

Back when the Web was spun, in the mid-1990s, Internet Service Providers (ISPs) quickly split off into three industries: Core networks, last-mile companies or web hosts.

Nearly all the last-mile companies, such as Earthlink, were destroyed early in the last decade as AT&T (NYSE:T) succeeded in effectively repealing the 1996 Telecommunications Act, with its guarantees of equal access. Core networks remain a viable business, albeit intensively competitive and not very profitable, as Level 3 (NASDAQ:LVLT) attests.

The best performers have been the Web hosts, but their success has stayed under the radar. That's going to change in 2012, starting with Internap's (NASDAQ:INAP) purchase of privately-held Voxel.

Paolo Gorgo of Nortia Research likes this group as I do. But my reasoning is based on the cloud.

The cloud is going to induce mergers in the Web hosting group, as companies find a need to scale-up in order to compete, both from within the industry and from without it. So look to the companies that follow for merger candidates.

While it's true that there is room for many cloud providers, it's also a business of scale. Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN) and Rackspace (NYSE:RAX) have a head start. Dell (DELL) and Hewlett Packard (NYSE:HPQ) are coming along. CenturyLink (NYSE:CTL) and Verizon (NYSE:VZ) see this as the final hope of the telcos.

The challenge for web hosts is to find the lower-end of the market, an area they already dominate. This starts by simply moving existing web hosting operations onto cloud infrastructure. Then these customers must be convinced to commit more resources to online operations.

All this takes money. So expect consolidation across the space.

In addition to Internap, data center specialists Interxion (NYSE:INXN), Telecity Group (OTC:TLCTF), both identified by Gorgo as growth candidates, as well as content delivery companies like Akamai (AKAI) and Limelight Networks (NASDAQ:LLNW) will be in the merger headlights, as the cloud complex works to expand its offerings and gain market share. Akamai's purchase of Cotendo doesn't end the pressure, but only makes the combined firm more appealing to the bigger players. InterXion's successful IPO may end up setting a price for the whole sector.

What this means for investors is you have two ways to make money. Prospects in this space are good, as Gorgo says. But I believe you'll also find some profitable take-outs here, especially as the risk-on trade increases in importance during the year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.