Japan's Phones Are The Coolest -- And Have The Skimpiest Profits

With their home market saturated, Japan's handset makers finally look abroad. Meanwhile, margins have plunged

When NTT Docomo (DCM ) unveiled its latest third-generation mobile phones on Nov. 17, gadget lovers were not disappointed. The new handsets, manufactured by five leading Japanese electronics makers, can download videos, play games, pay for groceries at convenience stores, and work as remote controls for TVs and other devices. Oh -- and they also make and receive phone calls. "This is the epitome of a 3G phone," says Takeshi Natsuno, DoCoMo's managing director for multimedia services. Not to be upstaged, Japan's other carriers are putting the finishing touches on their own new phones, featuring everything from music downloads to international video-calling on super-sharp color displays.

It makes sense. Take the world's most-advanced cellular market -- Japan -- and ask the world's top electronics houses -- many of them Japanese -- to provide the handsets, and you're sure to come up with the niftiest bunch of mobiles the planet has ever seen. But for all the technological wizardry that's about to hit stores, the companies building the phones are hardly prospering. A decade ago, the average profit margin for Japanese handset makers approached 10% as consumers snapped up millions of second-generation phones. Today, average margins have slipped to just 4%, according to Deutsche Bank (DB ). That's peanuts compared with international rivals Nokia Corp. (NOK ) and Samsung Electronics Co., which both posted margins of over 20% for phones last year.

The handset makers' low margins can be traced to two problems: a stingy domestic market and lack of foreign penetration. Domestical- ly, some 70% of Japanese now own a mobile phone, so it's tough to find new customers. And no matter how snazzy the features, subscribers are reluctant to upgrade their handsets unless carriers hand them over for next to nothing. The latest 3G models cost more than $500 to make, and that figure could reach $700 as features such as digital television are added, according to brokerage Goldman Sachs (Japan) Ltd. (GS ) But customers rarely pay more than $100 for a phone. "The days of double-digit profit margins are over. This is a rapidly maturing market," says Goldman analyst Ikuo Matsuhashi. He estimates that the production cost of 2G phones was about 20% less than that of 3G handsets. The selling price, though, was about the same.

Meanwhile, the country's mobile-phone makers have been singularly unsuccessful at marketing their products overseas. All of Japan's handset makers combined have a smaller share of the global market than Nokia alone: 16% for the Japanese, compared with 33% for Nokia, according to Deutsche Bank. Factor out their home market, and the Japanese share drops to just 6% -- or less than Motorola Inc.'s (MOT ) 14% and Samsung's 11%. (These figures don't include Sony-Ericsson, a London-based joint venture between the Japanese electronics giant and the Swedish telecom-gear maker. It has 5% of the global handset business.)

That may change as more countries adopt 3G. Japan's second-generation technical standard was unique to the archipelago, so Japanese handset makers focused on their home market, largely ignoring the GSM and CDMA standards that dominated elsewhere. In 3G, though, Japanese carriers have adopted technologies called W-CDMA and CDMA 1X, which are being rolled out in much of the world. And since Japan is the world's most advanced 3G market -- the service is in its fourth year -- the country's handset makers should have a leg up on global rivals. "The competition is getting stronger, but as of today, NEC (NIPNY ), Panasonic (MC ), and Sharp (SHCAY ) are ahead in the mobile-Internet business," says Yoshiharu Tamura, head of the mobile terminals operations unit at NEC Corp. "If we can stay half a step ahead, we have a good chance of success."

BETTING ON CHINA

It also helps that Japan's phone makers are well-versed in the audio and visual technologies that are likely to drive 3G. NEC, Sharp, and Sanyo already have prototypes that can display digital television streams, while Toshiba Corp. (TOSBF ) is developing a 0.75-inch hard disk for use in mobile phones that might double as MP3 players. "The handset industry is trying to find the next killer application," says Nahoko Mitsuyama, an analyst at Gartner Research (IT ) in Tokyo. "Japanese vendors believe audiovisual could be the one."

NEC is leading the pack. The company is Japan's biggest phone maker, with 2% of the global market and 22% at home. It's selling 3G phones to carriers in Europe and this year expects overseas sales to grow to 40% of its total, from 10% in 2002. Now it's turning its attention to China, which is expected to begin granting 3G licenses next year. The company says it will ship 2 million phones to China this year and 3 million next year. Among them is the $1,100 N900, which NEC launched in February exclusively for China. Roughly the size of a business card, the N900 is the world's smallest mobile phone.

Other players are equally ambitious. Sanyo Electric Co. (SANYY ) this year expects to sell 64% of its handsets overseas -- mostly to the U.S. In November the company said it will soon start shipping 3G handsets to France's Orange and that it hopes to sell 1 million 3G phones in Europe next year. Matsushita Electric Industrial Co. (MC ) is keen to grow its handset business in overseas markets, including China, Russia, and the Americas. Similarly, Sharp plans to hike its global handset shipments by 15%, to 10 million for the year ending in March, 2005, and in December plans to offer Europe's first 2-megapixel camera phone through Vodafone Group PLC (VOD ). Such ties with carriers in Europe may help the Japanese, who historically have had trouble making headway abroad because at home they left marketing of their phones to operators.

Still, there may be a shakeout among Japan's mobile-phone makers. One big problem is that there are too many of them -- 11 in all. That means cutthroat rivalry, of course, but it also leads to a shortage of qualified engineers and lots of duplicated research and development costs. Deutsche Bank analyst Fumiaki Sato says Fujitsu (FTJSY ), Toshiba (TOSBF ), Mitsubishi Electric (MIELY ), Hitachi (HIT ), and Casio would all be better served by ditching handsets and diverting resources to more profitable businesses. While Hitachi and Casio Computer Co. in April announced a new joint venture, none of the companies appears set to exit the business. Toshiba and Mitsubishi say they have no plans to get out, while Fujitsu Ltd. didn't return e-mails seeking comment.

Some observers say that even today, the Japanese remain too preoccupied with their domestic market. "Nobody has more experience with 3G and W-CDMA than the Japanese, bar the Korean producers. But so far I don't sense a coordinated, strategic plan for going after international markets," says Shiv Putcha, an analyst at market researcher Yankee Group (RJRSY ) in Boston. Unless Japan's phone makers can kick-start their overseas sales, all those nifty handsets will likely stay in Japan, just as they have for so many years.

By Ian Rowley, with Hiroko Tashiro, in Tokyo

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