Japan’s Ethernet Play Goes Awry

TOKYO — Despite technological leadership and steadily increasing sales, Internet Initiative Japan Inc. (IIJ) (Nasdaq: IIJI) can’t seem to make progress pay. Six months after President and CEO Koichi Suzuki promised investors (and, more importantly, Light Reading) an operating profit, the company looks to have little choice but to go for a bailout.

Back in May, following last year’s results, Suzuki told Light Reading IIJ was going to milk Japan’s rising bandwidth needs with a bunch of cutting-edge technologies and businesses, notably wide-area Ethernet and IP-VPN services (see Japan's Ethernet Elite).

In contrast to main competitors such as Japan Telecom Co. Ltd., KDDI Corp., and NTT Communications Corp., with their stodgy old Asynchronous Transfer Mode (ATM) services, IIJ and affiliate Crosswave Communications Inc. (Nasdaq: CWCI) have certainly delivered the services. And customers and capacity have surged (see Duo to Face Off With NTT).

Since May, IIJ has introduced 10-Mbit/s and 100-Mbit/s wide area Ethernet platform services, plus bells and whistles such as network monitoring and QOS (Quality of Service) features. Meanwhile, it’s grown its customer base to 313 from 136 a year ago. It will soon launch both a content delivery and an IP-VPN network and already has a 50 percent share of Japan’s CATV Internet market.

And IIJ has certainly grown with Japan’s bulging bandwidth demands. This past September, total Internet traffic through Japan's three commercial data carriers was 35 Gbit/s, 3.4 times that of the same period in 2001, says IIJ. Meanwhile, Japan’s Ministry of Public Management, Home Affairs, Posts and Telecommunications says ADSL subscribers shot up 8.4 times over the year to September to 4.2 million, while CATV Internet users reached 1.8 million, up 50 percent over the previous year.

In fact, for what it’s worth, IDC Japan predicts that Japanese broadband will continue to grow by 45.9 percent annually between 2002 and 2006, and the number of broadband subscribers in Japan will reach 18.8 million by 2006.

So where’s the money? Despite all the innovation, IIJ has been unable to turn its technical trailblazing into booming business. In May, Suzuki promised to increase revenues 20 percent year over year and boost the company to an operating profit. This now looks problematic.

For the first quarter, the company promised a loss. That loss was in fact ¥464 million (US$3.8 million) on ¥9.8 billion ($81.2 million) in sales – twice as bad as analysts’ estimates. In the past quarter, ending September 30, IIJ was supposed to have broken even, at least on an operating basis. But they lost ¥194 million ($1.6 million) on ¥10.6 billion ($87.8 million) in sales. It booked net losses of ¥4.8 billion ($39.8 million) for the half year.

Unfortunately for IIJ, sometimes it just doesn’t pay to innovate, especially when you have older telcos slashing prices, says Morgan Stanley Japan Ltd. analyst Hironori Tanaka.

In the first quarter alone, the costs of local lines and depreciation for building its Ethernet business wiped out the extra sales achieved by the new service, he says. Meanwhile, the old fixed-line competitors – Japan Telecom, KDDI, and NTT – have slashed per-megabit prices 30 percent over the year.

Tanaka, whose reports have been on the cautious side, found IIJ’s first quarter “painful.” He now says it is “very difficult” for him to believe IIJ can get into the black by next March. As late as August, Tanaka had them pegged for an ¥814 million operating income profit. At time of writing he was busy toting up expected operating losses.

IIJ argues costs and strong sales on its content delivery, CATV, and wide-area Ethernet will pull the company around, although it's not prepared to give any specific guidance for coming quarters, says PR spokeswoman Junko Higasa.

“They have already lost nearly ¥600 million so far, and I think the third quarter will be difficult for them as well,” Tanaka says.

UBS Warburg's Hiroshi Yamashina is buying IIJ’s argument, but only so far, pegging them at a fourth-quarter operating profit of ¥15-17 billion.

Throughout both press conferences this week, Suzuki repeatedly talked about boosting the scale of IIJ’s business. But as Tanaka points out, IIJ’s remaining capital is only ¥1.8 billion as of this last quarter.

— Paul Kallender, special to Light Reading
www.lightreading.com Want to know more? The big cheeses of the optical networking industry will be discussing Ethernet services and VPNs at Lightspeed Europe. Check it out at Lightspeed Europe 02.

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