Pihana's $240 million gamble

By John Duchemin
Advertiser Staff Writer

Pihana Pacific made the biggest splash of its short life last October by announcing it had secured $190 million in venture financing.

Nationally, the news was greeted with incredulity — how could a rookie technology company from Honolulu raise so much money after so many well-financed tech start-ups had failed? In Hawai'i, the deal was seen as a great sign for the local tech industry, which has struggled to attract capital.

A half-year later, Pihana has spent a good chunk of that cash, building an international network of data centers, heavily wired warehouses that Pihana wants to fill with the network servers of corporate customers. In early July, the company opened a 20,000-plus-square-foot center in Seoul, South Korea, to go with centers in Hong Kong, Tokyo, Singapore, Los Angeles, Sydney and Honolulu.

Now, the question is: Can Pihana fill those centers — or at least attract enough clients to make a profit for investors who put in more than $240 million? And in a gloomy economic environment, can Pihana even find enough paying customers to break even, before it runs out of cash?

Success could add credibility to the Hawai'i tech community, in which Pihana — founded in January 2000 — is already being held up as a role model for fund raising.

But the road to long-term survival, let alone profits, may prove rough.

Right now, with most of its centers open less than three months, Pihana has several dozen customers taking up less than 10 percent of its centers' sellable space — far less than necessary for profitability, CEO Richard Kalbrener said.

Data centers across the globe are running into a huge cash crunch, thanks in part to their own aggressive spending, in part to the drying up of capital markets, and in part to the slowing world economy. Many data center companies are going out of business — to the dissatisfaction of investors who poured billions into the sector, assuming that demand for the centers would grow far faster than it has.

"The whole data center sector is at risk because the big carriers are the only ones with deep enough pockets to sustain themselves," said Bill Richardson, a Honolulu venture capitalist whose firm, HMS Hawaii Management, has invested in telecommunications infrastructure companies but has no stake in Pihana. "That's the scary part of the data center business. It could be very lucrative, but it's a question of when."

Provides high-end services

So far, Pihana has stayed ahead of its industry's dangers.

The company curtailed plans for an expansion into India and other nations that would have cost tens of millions of dollars. And despite its short history, Pihana has already recast itself to better reflect the market's grim realities. The company, which started as a low-cost data landlord, now bills itself as a provider of high-end services that generate more revenue per square foot — and attract the best clients.

Kalbrener also insists the problems faced by most competitors — high debt, tepid demand, fierce competition — are not affecting Pihana.

"We have full funding into 2003, and even then we'll still have quite a bit of money in the bank," he said. "If the world goes to hell in a handbasket, we're still covered. No one has this type of situation except major corporations."

Still, Pihana's pockets, while deep, are not limitless. The company has spent about $125 million of its fortune on its build-out. Pihana also wants to acquire at least one more data center in Taiwan. That leaves less than $100 million to sustain the company, which has about 200 employees, including about 80 in Honolulu.

Kalbrener said Pihana's goal is to reach profitability by the end of 2002. He said Pihana is negotiating with dozens of potential clients, including blue-chip corporations — and has a headstart over many competitors who haven't completed their Asia networks.

Many observers said the company still faces some of the pressures that are killing other data center companies.

"The good news is that Asia isn't as overbuilt as the Mainland, and they [Pihana] have built their network, which gives them some lead time," said analyst Larry Ehrhardt, principal at Adventis, a New England telecommunications consulting firm. "But they still have to show their business model makes sense, or they could run into the same problems as everyone else."

The industry's biggest problem is oversupply, which has led to bargain-basement pricing in the year as hundreds of centers came on line around the world.

Data centers are essentially server vaults, in which client companies not only stow computer networks containing vital information, but connect to the high-speed cables that are the backbone of the Internet.

The concept is nothing new — big companies have had internal data centers since the mainframe era of the 1980s. But in the late 1990s, the cost of installing new equipment to handle the Internet drove many companies to seek other alternatives.

Early data centers in Silicon Valley and other technology hubs offered a handy solution: Bring your equipment in here, hook it into our Internet connections, and we'll spare you the cost of setting up your own network. These centers thrived, often maxing out their demand before construction was completed.

Buoyed by these successes, and by a massive influx of investor money, data center companies multiplied. The most aggressive players envisioned global networks of centers that would store and transmit much of the world's online content. Industry research firms predicted a $12 billion market for data center services by 2004.

Some were skeptical

The exuberance reached Hawai'i last fall. Pihana, a company founded by former Digital Equipment Corp. executive Lambert Onuma, in October announced its capital windfall, which included $100 million from Goldman Sachs, $40 million from venture firm Columbia Capital and millions more from investors including Hewlett-Packard, Morgan Stanley Dean Witter and PacifiCap, a Hawai'i venture firm.

This put Pihana on the star circuit in Hawai'i, where tech watchers hadn't seen such a big investment deal since locally bred communications company Digital Island got millions in venture money in the late 1990s.

But the announcement elicited skepticism from observers including national venture-capital magazine Red Herring, which called it the "Deal of the Day" but cautioned that Pihana "has no customers, no revenue, and faces an uncertain future in increasingly volatile waters."

The waters proved stormy in the following months. The industry, caught up in insiders' giddy forecasts, got far ahead of itself. Supply of data center space outstripped demand, which proved weaker than expected as the dot-com bubble burst and Internet companies — staunch data center clients — began to fail.

Adventis' Ehrhardt estimates that supply exceeds demand for data center space by 50 percent. Many start-up data centers now find themselves hugely overbuilt, with few customers, minimal revenues and millions of dollars in construction debt. Capital sources are scarce, in part because investors burned by bad investments are reluctant to support shaky companies.

As the losses pile up and stock prices plunge, many data centers are going bankrupt, laying off hundreds of employees, curtailing projects and shutting down unprofitable facilities.

The crunch has claimed several victims in Pihana's core markets. In Hawai'i, Mid Pacific Broadband Inc.'s plans for a Wal-Mart-sized, $125 million data center in Kapolei bogged down in the spring as the company failed to raise the necessary money. Construction has been postponed indefinitely.

In Asia, Pihana rival iAsiaWorks in June announced closure of its three Hong Kong data centers, laid off 127 workers and faced a class-action lawsuit from shareholders, who claimed the company had understated its capital needs during an initial public offering last fall.

Pihana has moved ahead with its build-out despite the aura of impending disaster that surrounds much of the industry.

Several observers say this gamble could give the company a leg up in attracting customers, who may have nowhere else to go — but it's still a gamble.

"Pihana is building the data center equivalent of a five-star hotel," said Burt Lum, founder of rival Honolulu firm NetEnterprise. "But the market might not be suited to five-star hotels. The whole model is based on some incredibly bullish forecasts by analysts who are really strong on where the Internet is going. If none of that is true, then what you'll still have is a big glut of space."

Lum said smaller data centers are more cost-effective and operationally agile. Lum says his 3,500-square-foot center in downtown Honolulu is now more than 60 percent full and is turning a profit — as opposed to Pihana's 10,000-square-foot center near the airport, which has a handful of clients and row upon row of empty server racks.

Kalbrener acknowledged the Honolulu market is not ripe for Pihana's services. But he and others said the bigger-is-better Pihana strategy will work in the international market, where capacity, security and quality are all must-haves.

One of Pihana's fans is Earl Ford, founder of Honolulu-based Internet firm SystemMetrics.

One of the first customers in Pihana's Honolulu center, Ford said Pihana is a "natural fit" for his company, which designs corporate Internet systems and offers Web hosting and high-speed Internet services.

Pihana is Hawai'i's only "class A" data center, Ford said, and is worth the price, which is a hefty premium over NetEnterprise and other small local competitors.

But he cautioned Pihana not to expand too quickly.

"Once you've built those centers, they're huge overhead until you fill them up," he said.

Reach John Duchemin at 525-8062 or jduchemin@honoluluadvertiser.com.