Appliance-server pioneer Cobalt Networks Inc. is planning an initial public offering, despite growing competition from major firms such as Compaq Computer Corp. {CPQ} and IBM {IBM}. The looming turf war illustrates the growing importance of the still-nascent appliance-server market.

Mountain View, Calif.-based Cobalt’s planned IPO, announced earlier this month, might be expected to draw investor interest, given the company’s success selling appliance servers, one of the hottest new categories of the computer-equipment sector. But despite the overwhelmingly rave reviews being given to Cobalt’s innovative product line, several analysts say there may be better bets in the sector.

Servers are machines that store and serve data within a company or over the Internet. Appliance servers are a specialized type of server. General-purpose servers, which must be programmed by experts, can be cumbersome and costly to set up and maintain.

Less-expensive appliance servers, on the other hand, sometimes called "black boxes," are designed to perform highly specific tasks, such as providing a small business with Internet connectivity, e-mail accounts, Web publishing, or even more specialized services such as medical-record collection and distribution.

Cobalt’s e-mail server, for example, has Internet service providers "jumping up and down," says Kimball Brown, vice president at Dataquest, based in San Jose, Calif. That’s because ISPs can now buy an inexpensive $999 box off the shelf and get the machine up and running almost immediately, enabling ISPs to expand capacity at a far lower cost than was incurred with previous technologies.

"Its a very compelling proposition," Brown says.

In fact, it’s such a compelling proposition that much larger companies are already hopping on the bandwagon. The major players in the computer industry are flocking to the appliance-server market in response to strong projected demand.

According to estimates compiled by Dataquest, the server-appliance market is projected to grow to about $15.8 billion in 2003 from $2.2 billion in 1999, representing a stunning 64% compounded annual growth rate.

Part I: Cashing in on the Coming Server Boom

Sales of server appliances that use the Linux operating system, Cobalt’s particular specialty, are expected to grow by about 69% a year, representing about 24% of the total server-appliance market, or $3.8 billion, by 2003, according to the same firm.

Nonetheless, the mismatch between huge companies such as Compaq, Dell Computer Corp. {DELL}, and on one side, and relatively tiny Cobalt on the other, leaves some analysts worried about Cobalt’s prospects.

"Cobalt Networks is an investment fraught with high risk," warns Stacey Quandt, an associate analyst at Giga Information Group, based in San Jose, Calif., in a recent report.

Quandt agrees that the overall appliance server market will continue to expand over the next few years. "However," she says, "the companies that will reap significant rewards will most likely not be the Cobalt Networks but the Dells and IBMs that deliver branding and can provide significant global services and support."

While that’s not good news for Cobalt, it’s wind in the sails of the largest server makers. According to analysts, two of the strongest new appliance-server products are Compaq’s Prosignia NeoServer and IBM’s Whistle Interjet server.

IBM one-year stock performance chart

Despite IBM’s strength, or more accurately because of it, Compaq is better-positioned to benefit from the expected surge in appliance-server sales, says Daniel Niles, an analyst at BancBoston Robertson Stephens, based in San Francisco.

"IBM does something like $25 billion in revenues a quarter," Niles says. "[Appliance] servers won’t have much of an impact on them. You want to get a company that is more exposed to the market. Compaq and Dell, those are the purer plays."

IBM one-year stock performance

DELL one-year stock performance

Although Compaq has been stung by recent management turmoil, the company’s dominant position in the general-purpose server market should give it a leg up as it expands into the fast-growing appliance-server sector. Compaq has been slow to adapt to some major recent computer industry trends, such as direct marketing, but this time around, the company appears better-prepared to play a leading role in an important new emerging market. The competition could intensify, however, if Dell, also a leading supplier of general-purpose servers, successfully introduces a line of appliance servers sold directly to businesses, as many expect.

If that happens, Compaq, IBM, and other major vendors may have a tougher fight on their hands. Cobalt, though, "would have even more to fear," Quandt says.

For the six months ended July 2, Cobalt posted losses of $8.2 million on revenue of $7.7 million. The precise date for the company’s IPO hasn’t yet been set.

Part One - Cashing in on the Coming Server Boom