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Digital River Adopts A Risky Strategy

Digital River may be the largest E-outsourcing company in the world. But can the electronic software-distribution service successfully remake itself into a leading E-commerce software and services firm?

If there's a Madonna of the application services market, it's Joel Ronning. The 45-year-old CEO of Digital River Inc., an E-commerce application-hosting firm, has a penchant for reinvention. Ronning certainly has the chutzpah of an international pop star. He says Digital River, with $31.2 million in revenue last year and $400 million to $500 million worth of online transactions flowing through its E-commerce infrastructure every year, is the largest "E-outsourcing" company in the world. But it's uncertain whether his efforts to remake the company from an electronic software-distribution service into a leading E-commerce software and services firm will be a success.

When Ronning launched the company in 1996, Digital River specialized in electronic distribution of software, enabling people to buy and download software over the Internet, from the likes of Symantec, Novell, and Autodesk. In 1999, Ronning sought to capitalize on the E-retailing boom by tailoring Digital River's online transaction services to retailers and manufacturers, such as Nabisco and Siemens, looking to set up shop online. While the electronic software-distribution business makes up more than 75% of the company's revenue, Ronning says nonsoftware business is the faster growing segment.

But the company's third quarter, which ended Sept 30, tells a different story. On Wednesday, the company reported $14 million in revenue, a 7% increase over the previous quarter and an 84% increase over the same period last year. While the company's software services division grew 12% from $9.5 million in the second quarter to $10.6 million, its E-business services division, the one that caters to nonsoftware companies, declined from $3.6 million the previous quarter to $3.4 million. Losses in that division deepened from the previous quarter as well.

The shrinkage came despite the fact that the company has made several acquisitions expressly to grow that side of its business. So far this year, Digital River acquired the assets of Net Sales, an online sales software firm on it last legs; the E-marketplace division of struggling Calico Commerce; and most recently Orbit Commerce, which hosts E-business applications for 3,500 small-business customers through reseller relationships with Gateway, VeriSign, and Cincinnati Bell, among others. By bringing Orbit into the fold, Digital River hopes to boost the E-business services division, which accounts for only 100 of its more than 8,000 client sites.

The company's strategy: scoop up the customer bases of smaller competitors on the cheap and transition them to the Digital River platform, discarding the infrastructure of the companies it acquires. The company says it keeps its cost structure stable this way, while growing its revenue base and consolidating the lower end of the market. It's acquired eight companies in the last two years, and with no debt and more than $25 million in the bank, it has its eye on another 20 struggling companies. "We buy small companies, shut down their infrastructure and their data center," Ronning says. "We take their customer base and put it on our technology."

It's a risky strategy, analysts say. For one thing, companies that have trained staff, integrated back-end systems, and invested in infrastructure to support an E-commerce platform are loath to migrate to another platform, even if it's technically superior. And even if customers agree to migrate, doing so may involve a long and costly transition requiring data translation and customer hand-holding, denting Digital River's hopes of keeping its costs down. "Even if all the functions are supported by the new platform, even if the interface is better, there is sure to be a bump there," says Kyle Johnson, an analyst at Forrester Research.

To its credit, Digital River has grown at a decent clip this year. If it meets its projection for $57.6 million in revenue, it will have grown nearly 85% over last year. Not bad in a grueling year for the software and hosting markets. Perhaps more important, the company says it will turn a profit this quarter, not including charges related amortization of goodwill and acquisition-related costs. Digital reported a loss for the quarter of $4.4 million, or 18 cents a share, or $462,000, or 2 cents per share before such charges. Profits are a longer way off for larger competitors in this market, such as USinternetworking Inc. and Corio Inc.

Do you think Digital River can successfully reinvent itself? Can a merger-and-acquisition strategy work for the long haul? Share your opinion in the Talk Shop discussion forum.

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