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.