This story appeared in "Ten Turning Points," featured in the September 2004 issue of Web Host Industry Review magazine. Click here to subscribe for free.
October 25, 2004 -- (WEB HOST INDUSTRY REVIEW) -- In the Web hosting industry, where many businesses compete on price above anything else, the "loss leader" strategy of offering a service at a loss as a means of drawing in customers was simply a logical extension of a price-cutting culture that had already taken hold. Selling at a loss has allowed hosts to break into new markets and expand their customer bases, raised the industry's profile and pushed forward the commoditization of certain segments of the business.
"Hosting companies use loss leaders to grow the customer base exponentially," says Barbara Branaman, vice president and general manager of the hosting unit at XO Communications (xo.com), "with the ultimate goal being to up-sell these customers to more profitable business."
Hosting companies also use loss leader strategies to break into markets where they lack brand identity, says Helen Chan, senior analyst at the Yankee Group (yankeegroup.com). Loss leaders, with their eyebrow-raising effects, are usually useful in generating publicity for a brand and boosting its profile.
Frequently, the motivation is competition. Companies undercut prices to stay competitive amid constantly dipping prices. Some hosts have embraced loss leader strategies because of their upside. Typically, domain registration or low-priced shared hosting plans are offered at a loss, targeting the price-sensitive small and medium-sized business market.
Domains, in particular, have been a popular vehicle for this strategy because their smaller margins make the losses easier to absorb. In the past two years, EV1 Servers (ev1servers.net), Hostway and Go Daddy have all dropped prices to under $10, losing money on registration to attract new customers for other services.
1&1 Internet's US division (oneandone.com), launched this year, is also selling domains at a loss, charging only $5.99. But that's not the boldest example of the company's use of loss leader strategy. To promote its entry into the US market, 1&1 offered free three-year trials of a $29-a-month shared hosting plan, a value of $1,000, to everyone who signed up. Europe's largest host chose to break into the crowded US market and raise the profile of the 1&1 brand by selling (or giving away) its services at a dramatic loss.
"1&1 Internet has used [loss leader] campaigns ... as a way of raising awareness and allowing people to experience our products and services for themselves," says Michael Frenzel, vice president of public relations for 1&1. He says the company has made up some of the losses as customers happy with the free hosting promotion have purchased other services. 1&1 also hopes to create permanent customers, who will remain beyond the three years.
While there are arguably benefits to drawing in customers with unbeatable prices, it's still a risky strategy. Hosts are betting that the expanded customer base brought in at loss leader prices will help create economies of scale that eventually make the price levels profitable, says Haralds Jass, CEO of Superb Internet. But, obviously, not every host possesses 1&1's scale.
For many hosts, such strategies are gambles that have to draw in enough customers to create the right economies of scale, and assume that customers will stay. Many hosts, says Jass, are unable to deliver on their promises, given their below-cost prices. Failure to deliver not only gives the company a bad name, but can create a black eye for the industry in general.
Loss leaders can also "attract the wrong type of audience," says Branaman, leaving a host with a "base of customers that are not loyal to the services or interested in additional services, therefore making the overall business unprofitable."
Just as the service-at-a-loss strategy has distinct advantages and disadvantages for the individual Web host, the consensus seems to be that the strategy is both good and bad for the Web hosting business.
Loss leaders certainly bring attention to the industry, says Jass, and help create new customers. They also push hosting providers to operate at a greater value and efficiency. But aggressive loss leaders can hurt the industry by creating a lower price floor that may commoditize the market in the long run, forcing new companies to come in at lower price points.
The strategy can put undue pressure on smaller hosts who feel compelled to sell at slim margins, or at a loss, in order to stay competitive. If hosts in this position attempt to compete by overselling storage or bandwidth, they may stretch their resources too thin, putting themselves in position for an embarrassing or expensive collapse.
Certainly, the constant downward pressure on the price of standard hosting services and related products has played a significant role in shaping the landscape of the hosting business. And, with price as one of the chief areas for competition in Web hosting, it only stands to reason that loss leader strategy would emerge among the most aggressively competitive. Whether those companies are able to turn losses into profits, however, still remains to be seen.
