Those who like software dished up this way aren’t going on faith alone. One company, VeriSign, shows that offering up software as a service can work profitably. VeriSign, which sells encryption services for e-commerce sites and corporate communications, posted $474.8 million in revenues last year, up 460% from a year earlier. Pro forma net income hit $45.5 million. VeriSign is a winner because it spotted a technology needed by every company doing business on the Net, then beat others to the punch by offering it as a service.

That sets the stage for a bruising battle this year. With piddling revenue streams to be had in the short run, the early ASPs will fight desperately to get the formula right while next-generation companies pile into the market. And the old behemoths? Don’t count them out. They, too, want a piece of the action. "The software business is going to change fundamentally in the next three to five years," predicts Oracle chief executive Lawrence Ellison. "Oracle is going to be ahead of that charge."

Some of the pioneers now seem to be on the right track. USi has rounded up 170 customers, and its revenues grew 208% last year, to $109.5 million. Analysts project revenues this year around $165 million, with the break-even point coming in the third or fourth quarter. The best news is that USi has finished building three huge data centers for running the software, which analysts say totaled more than $300 million. Another leader, Corio, reported revenues of $43.6 million last year, up 650%. Analysts project $75 million in revenues this year and profits early next year. Both companies are now asking customers to pay part of the cost of software licenses up front. They have skirted problems encountered by some of the ASPs that failed, such as Pandesic, which tried to make money off of fees based on its customers’ e-commerce sales.

No matter how well they tune their engines, though, the first generation ASPs will have a tough time outperforming the newer entrants. The newbies establish one super-reliable Web site that all their customers hook into—plugging their information into simple templates. They don’t have to buy a new set of server computers for each individual customer, as the pioneers do. If the Young Turks get it right, the economies of scale could produce gross profit margins topping 90%—dramatically better than the 70% average among traditional software makers and the 15% to 20% margins that early ASPs have achieved, say analysts. Boasts Marc Benioff, chairman of sales-force-automation ASP salesforce.com: "We are going to kill traditional software.’’

Don’t think that big software companies will oblige Benioff. Microsoft, for instance, is betting its future on an online-service strategy. In addition to allowing ASPs to rent out such desktop applications as Word, Microsoft is building a technology foundation upon which other companies can build their services.

With a market as embryonic as this one, it’s too early to call winners. The Microsoft of the ASP world might not even be alive yet. But, already, some of the contestants are promising. Analysts especially like VeriSign’s prospects, since it has a proven track record and a dominant 75% share of the market for Internet encryption.

While the notion of software as a service could turn the traditional packaged-software world upside down, the approach has deep roots in computing. For decades, companies such as IBM have run other people’s software from their data centers for a monthly fee. When the Internet came along, Web-hosting companies managed sites for tens of thousands of companies. USi’s innovation was to offer the full array of corporate applications—from accounting to materials planning—as services delivered via the Web. IDC dubbed this an application service provider.

For a while, the computing world was nuts about ASPs. At the height of the mania, in the fourth quarter of 1999, venture capitalists pumped $2.5 billion into these companies. That was half of all the money invested in new software companies that quarter, according to McKenzie Consulting.

So what went wrong? The biggest obstacle has been inertia. It’s just plain hard to persuade people to try something new. In interviews with more than 25 corporate customers, BusinessWeek found balky executives. Corporate IT departments are reluctant to give up control over their computing systems. CEOs are worried about Net security and fret about handing important business data over to another company, though those fears have so far proven to be unfounded.

Missing link

For some, the numbers simply don’t add up. The ASPs claim they would have been cheaper partly because they believe Abraham underestimates the cost of building and operating fail-safe computing systems like the ones they provide.

When ASPs do manage to land customers, sometimes they fail to deliver the goods. Even among customers who get satisfactory service, there’s a tendency to move cautiously. At Hershey, for example, just one tiny portion of the company, an e-commerce site called Hershey Direct, has gone online with an ASP. The rest of the company’s computing systems are run through a separate computing division that sticks to running software the old-fashioned way.

Now ASPs are reconciled to slower growth than they had first expected. That’s why they’re focusing on profits. ‘’The market is much different than it was a year ago,’’ says USi CEO Andrew Stern. To cut costs, USi laid off 11% of its staff in January. Now it’s asking customers to pay at least 20% of the total cost of a contract up front.

While USi and Corio are struggling to get on a winning track, they’ve got to be wary of the next generation of ASPs who are coming up from behind. In little more than a year, salesforce.com has landed 1,700 paying customers and 25,000 companies are participating in free tryouts. NetLedger.com, which provides small-business accounting services, has 3,000 customers. It’s just a very different proposition than the one USi and Corio face. Since these newbies build their technology themselves, they don’t have to pay a software supplier for programs.

It’s low-risk for customers, too. While second-generation ASPs don’t have all the bells and whistles of a mature software program from PeopleSoft or SAP, they make it very easy for customers to sign up and use the services. For NetLedger’s service, the price is just $9.95 a month to start. A corporate customer can add more users at any time, and they also can drop them.