Michael Porter, the legendary competitive strategist is well know for his five forces analysis. The analysis evaluates an industry on how attractive or unattractive it is based on the overall profitability that could be achieved. I was curious to look at the CDN industry from this perspective.

Porter points to five different forces that affect any industry – the threat of substitute products, threat of new entrants, the bargaining power of customers, the bargaining power of suppliers and last but not least the intensity of rivalry among the competition. The profitability in the CDN industry has been eroding despite the growth in demand. Perhaps these forces can shed some light in explaining this paradox.

Let us look at each of them in turn:

Threat of Substitutes

CDNs essentially sell the ability to move large files (typically videos) across public networks. You do not need a CDN if you stream videos from your hosting providers for a small portal. But as you scale your portal to the levels of myspace, you will need a dedicated system that can scale serving videos to meet the users’ demands. While the likes of Google and Yahoo! have built out their own networks, most others including Microsoft rely on a CDN.

It seems that there are no credible alternatives to CDNs services yet. However, there has been a lot of talk about cloud services from Amazon, Oracle, Microsoft and others. Amazon has a new product called CloudFront that competes at the basic service levels, but it is yet to be a real threat to the CDNs.

Threat of New Entrants

The CDN technology has evolved quite a lot over the last 10 years. However, it is too early to say that technology has matured. There has been a flurry of new ventures betting on P2P models of content delivery over the last few year – Pando, Vusion, Abacast, Grid Networks to name a few. While the success has been limited, some CDNs realize the complementary potential of a hybrid P2P model. The P2P model has some real advantages when it comes to scaling live video delivery. However, the barrier to entry is quite high as Dan Rayburn explains.

On a different front, large service providers like AT&T and Alcatel-Lucent are getting into the CDN game. They have a great advantage of the economies of scale and a large enterprise customer base to be a more effective threat. Recently, Alcatel-Lucent gobbled Velocix, a CDN which had announced Metro to differentiate itself from the pack. It is very likely you might see more such deals in the coming year.

Bargaining Power of Customers

CDN customers are typically large portals like facebook, fox, ESPN, NBA, Kaiser Permanente etc. who have a great need for streaming content to internet users. Most CDNs have a few large customers (for example Microsoft accounts for more than 15% revenue of LimeLight) which gives the customers a huge bargaining power over pricing.

The way a deal is typically made is to agree on an SLA for given level of bandwidth commit for a specified duration like a year or two. The content delivery itself is pretty abstracted out from the content management systems for most customers. This allows for the customers to switch between providers as the contract nears an end. Smaller CDNs exploit this to woo customers by lowering their prices substantially. The low switching overhead has prompted the large CDNs scrambling for differentiated offerings.

Another interesting area of customer pressure seems to come from Video Delivery Platforms such as Brightcove. These companies fill the important need of managing all the video assets for their customers. They provide value added services like player customization, video asset management, analytics and other helpful tools under one umbrella to provide a complete solution. In a sense, they have commoditized the value CDNs bring to the table. They typically buy bandwidth from the CDNs and have very high negotiating power to instigate price wars.

Bargaining Power of Suppliers

The large CDNs typically have around 30% gross margins and over 50% of their cost of revenues come from buying bandwidth from backbone providers and buying servers and storage. The supply of bandwidth itself is competitive as the network providers and telcos compete for customers.

Given that the large telcos like AT&T and Verizon have their own plans of offering CDN services, it is a forward integration that could take foothold as the demand saturates. The current economic downturn may delay this transition.

The Intensity of Rivalry among the Competition

The largest CDN perhaps has around 3000 customers while a smaller one might have just a few customers. The low switching cost for customers has paved the way for price wars among the new entrants and the smaller CDNs. However, the larger CDNs enjoy a relatively stable customer base and thus far they have been successful to sweeten the deal sufficient to keep their customers.

Nonetheless, it has been hard for even some of the larger CDNs to be profitable. Most CDNs provide services using similar technology. The CDN industry is famous for their patent infringement lawsuits. This has led to high volatility in the stock prices and earnings losses.

Lately, there has been some consolidation taking place among the CDN providers. Panther Express merged with CDNetworks, Velocix got acquired by Alcatel-Lucent. Those CDNs without deep pockets to weather the price wars and the economic downturn are likely to follow suit.

Conclusion

The CDN industry is highly competitive and it is quite hard for a new entrant to be profitable. The players are yet to establish very good differentiators to lock in their customers leading to a price war. In spite of the phenomenal growth in online videos, the CDN service is commoditized by value added players who might steal the game from the CDNs. We might likely see some mergers and acquisitions in the near future.

We all have witnessed phenomenal growth of online videos in the last few years. At this time, it is a forgone conclusion that TV viewing has declined primarily due to the onslaught from online videos. The latest figures say that 77% of US internet users watch an average of 87 videos per month. This is a whopping 12.7 Billion views per month. Any e-marketer out there would be drooling for these massive eyeballs.

Industry Leaders and Drivers

Who stand to benefit from this gold rush? Consumers for sure are, but apart from that, there are a handful of companies that help deliver these video bits to you over the internet. Every time you watch a video, there is money exchanging hands. These content delivery networks (CDN) get paid by the number of bit delivered from where the videos are hosted to where the user consumes them.

Frost & Sullivan reports that currently, the CDNs make a total of $400 million a year and the rate is growing at 30% compounded annually. 80% of this is captured by just 4 companies – Akamai, LimeLight, Level 3 and CDNetworks. For the rest of the 20% of the market, around 40 smaller CDNs compete ferociously.

In spite of this rosy growth picture, it is interesting to watch the dynamics within the CDN industry. The price that CDNs could charge have drastically come down putting pressure on their businesses. The price for a gigabyte of data delivery now stands anywhere between 50 cents to a few cents depending on the volume of delivery committed. This is in contrast to over $2 per gigabytes back in 2000. A couple of factors have contributed to this decline. One is the binge of fiber optics that got laid for expanding the internet during the dot com boom. Second, there have been a growing number of businesses springing up causing the competition to drive down the price. Akamai, who has been the leader in this space, has seen business eroding to competition over the years as the buyers of bandwidth can switch to other providers without much difficulty.

The CDNs are in a frantic rush to attract and retain additional customers to keep up and grow their revenues. In this mad dash, some of the CDNs have seen their profits eroding for years. It is interesting to ask the question of how CDNs can capitalize on the growth of online videos or if their price wars would lead some other businesses to take the loot.

Apart from the CDNs that deliver the bits to the end users, there are other players emerging in the business of online videos. There have been a host of video delivery platforms springing up ever since youtube became popular. These companies like Brightcove and Ooyala provide value added services like player customization, video asset management, analytics and other helpful tools under one umbrella to provide a complete solution. These companies typically buy the bandwidth from one of the CDNs. Because of the large volume of bandwidth they can commit, they usually get a very favorable price.

The video delivery platforms have in a sense commoditized the CDN services. Only the large players like Akamai can withstand the pricing pressure while most of the smaller players may leave the market in the near future. As you can see, the competition seems to be switching from the CDN bandwidth providers to video delivery platforms with many more companies joining the fray. In the next couple of years, we will witness aggressive customer acquisition battles between these companies.