ZTE shuts down after US ban

09/05/2018

China's ZTE paid over $2.3 billion to U.S. exporters last year, ZTE...

Chinese technology company ZTE Corp , which this month suspended its main operations after a U.S. Commerce Department ban on American supplies to its business, paid over $2.3 billion to 211 U.S ...

https://www.reuters.com/article/us-usa-china-zte/chinas-zte-paid-over-2-3-billion-to-u-s-exporters-last-year-zte-source-says-idUSKBN1ID020

First of all, rest assured that ZTE won’t go bankrupt in next few years, as it is almost impossible for a de facto SOE like ZTE to be out of business, however this ban is still a big blow to its ambitions for expanding the overseas market.

The primary business of ZTE is telecommunication equipment, government-enterprise business and consumer business, and it is a listed company in both Shenzhen and Hong Kong. Hence we could obtain its financial reports in an easy way, I have generated a few pie charts from the public available data:

It’s not hard to find the following facts:

• Telecom equipment accounted for proximately 80% of ZTE’s profit;
• Chinese market contributed 65% of ZTE’s profit;
• Europe, North America and Oceania constituted less than 20% of ZTE’s profit.

That being said, ZTE is primarily a Chinese domestic company that sells telecom equipment to Chinese telecom operators, US commerce department’s export ban is a terrible blow but not going to be fatal anyway. ZTE and Chinese government still have a few of measures to resolve this crisis:

• ZTE is still able to purchase microchips from the US via its agents or shell companies, it isn’t a big issue as long as its products are only sold in China.
• Without a doubt, Chinese state-owned telecom operators will lend a hand at this juncture. Chinese government has no reason to sit idle, considering that ZTE is a de facto SOE and it has always been on the front end of the government’s foreign trade & investment policy.
• ZTE will gradually adjust its supply chain in the coming decade, getting rid of dependency to the US‘s technology bit by bit. Meanwhile Chinese government will be pouring tons of money into the semiconductor industry, in the hope of getting the key components being localized.
• ZTE’s overseas market will unavoidably be carved up by Huawei, Ericsson and Nokia communications.

In terms of the Android operating system, ZTE doesn’t really need Google’s authorization in order to use its source code (AOSP) , as Android itself is a piece of open source software under the Apache License 2.0 and GNU Public License v2, US commerce department and Google have no say in this as long as ZTE doesn’t include Google builtin Apps (Google Play, Gmail, Google Map, Youtube etc) and GMS (Google Mobile Services). Even in the worst case, ZTE can still use Yun OS which is almost 100% compatible with Android.

 Steven Lee  20/04/2018

There were many good reasons why this cross-border supply chain developed the way it did over the last two decades with significant time and capital invested to optimize it over time. Being forced to re-create the supply chain by finding alternative sources and vendors will take additional time and capital for all involved parties and the end result after an adjustment period is most likely to end up less efficient and more expensive for the ultimate end-consumer.

Beyond the impact to parties that are directly involved (ZTE, U.S. technology and component suppliers) there is the increased uncertainty and the risk/prospect that this is merely the next salvo in a gradually escalating trade battle/war.

The long-term impact and “winners” will depend on how each country reacts and how their economies adjust to the coming changes. There is also the question of how long (politically) such a trade battle can be sustained by either side.

It will likely have to shutter sales of consumer handset sales to U.S. and re-design its handset using non-Qualcomm chips. Or possibly spin-off or sell its handset business (which isn’t really that valuable compared to its core network equipment business). It will have to re-design some of its communications and networking gear without U.S.-designed chips and components — meaning sourcing from European/Asian and domestic suppliers.

From a purely financial perspective, shutting down the consumer handset business is not such a big deal for ZTE even though the U.S. is one of its largest markets and there is significant U.S. content in its phones. This is because while the consumer business accounts for 32% of its revenue, it accounts for less than 6% of its profitabilityAs I have outlined in a previous Quora answer. China’s direct value add in the consumer handset business is relatively low from a hardware perspective. Android-based handsets are fairly commoditized and while there might be some temporary supply chain disruption, component suppliers will just shift their supply to other handset manufacturers (e.g. Xiaomi, Vivo/Oppo, Samsung, LG etc.) as the market responds to fill in the void created by ZTE’s exit. U.S. consumers may be slightly impacted in the form of higher handset prices (for low-end smartphones) but frankly I do not think this will be that significant.

Like Huawei, ZTE’s “operator network” business — i.e. selling communications equipment to large carriers — accounts for the vast majority of its profitability. So the substantive question here is how this edict affects this part of its business.

ZTE does not sell its networking gear to the U.S. market. This is part of the de facto ban on Chinese telecom suppliers by U.S. regulators. But while ZTE does not depend on the U.S. market for revenue, it does depend on certain U.S. component suppliers for some critical pieces of technology that go into its equipment.

Understanding the level of ZTE’s dependence on American technology requires a bit of a dive into how this equipment actually works and the industry dynamics of each of its various pieces, from chips and components to software and services.

---

Telecom equipment is complex and requires very high-speed processing of both digital and analog signals. At a very high level, the equipment needs to convert analog signals into digital ones, process it with various algorithms and then potentially convert the digital data back into an analog signal so it can be passed along to the next node. There are often many nodes along the way, and this process often repeats itself multiple times as a packet of data makes its way to its ultimate destination. There is also overlay software and services that manages and coordinates the entire system — disparate pieces of equipment working in tandem to seamlessly move data packets in every direction.

And of course this all needs to happen at very fast speeds so that consumers can sit comfortably in our homes and stream Netflix or play Overwatch without that dreaded lag.

Chinese companies like ZTE do a pretty good job on the software and services aspects of the network equipment business. Indeed, as Chinese software and network engineers are significantly less expensive than American and European ones, this is probably their key source of competitive advantage as they bid for global telecom projects.

There are also certain commodity chips and components that go into networking gear that are also fairly non-differentiating in that they can be sourced from multiple vendors, including Chinese ones, at an acceptable level of cost and quality.

But there are certain critical components in networking gear that can impact overall performance — especially the specialized chips involved in high-speed processing of analog and digital signals. One example is a module that converts an optical signal (analog) into a digital signal in optical networking equipment. This module is one of the key bottlenecks enabling the gear to meet the extreme throughout demands of carriers and data centers. The chips that enable cutting-edge speeds are highly specialized and there are only a small number of firms in the world that have this high level of design capability. And a disproportionate share of these companies are based in the United States, a legacy of our long history of technology leadership.

Cutting-edge semiconductor design — especially for processing analog signals — is a major gap for Chinese industry. Talent is both highly specialized and concentrated and intellectual property is not easily replicated as it is based on trade secrets and intricate processes that have been refined over decades. Even if you are able to perfectly replicate and reverse-engineer an existing chip design you do not have the requisite knowledge to tweak and improve upon the design. And this is an industry where performance must evolve at a fast pace just to keep up … good ol’ Moore’s Law at work.

Semiconductor expertise is not something that can be built overnight. On the manufacturing front it took Taiwan three decades to catch up — and it did not have to deal with restrictions on the export of certain specialized semiconductor capital equipment that Chinese companies have to contend with in this area.

So while they can handle the top-level design, software and services portions and manufacturing of these systems quite well, Chinese telecom companies like ZTE have historically relied heavily on foreign chip suppliers for some of the most important components of their systems. In return, these component suppliers have been rewarded through the years and supported many high-paying American jobs. This is the classic economic principle of comparative advantages at work in the real world.

If the ban holds, ZTE will likely have to re-design its equipment to incorporate alternative suppliers for some of these mission-critical components. This will take time (multiple years) and capital. I do not think this will necessarily put ZTE out of business — it can still rely on its core China market — but it will definitely hurt. At the same time, American component suppliers will also feel the pain. One supplier disclosed that ZTE represented nearly one-third of its revenue and its stock has predictably plummeted.

---

The broader, long-term impact depends largely on how the respective economies and involved parties react to these rising restrictions on bilateral U.S.-China trade. Several scenarios that I can see happening:

• Affected chip companies re-domicile outside the United States. Worse yet, companies affected by this edict shut down U.S. engineering offices and transfer/re-hire resources to another country (e.g. the United Kingdom or Germany) so that they can continue to sell to Chinese telecom companies. The IP and chip designs themselves are probably already held in an offshore entity for tax reasons anyway.
• ZTE spins off its consumer handset business or sells it to another Chinese company to provide some separation from the “taint” on the more politically sensitive network equipment business.
• China doubles down on its strategic goal of developing its own semiconductor industry. This latest edict only confirms the importance of moving more quickly towards that goal. Already I have seen near-instant reaction in the form of experienced overseas Chinese chip engineers leaving or being fired from impacted chip firms and deciding this next move is to set up shop in China — with significant financial backing.
• We also cannot ignore the impact this may ultimately have on the 2020 U.S. election. Trade wars are fought by the executive branch of our government and there is certainly a distinct possibility of a new executive branch — with completely different trade policies — in two or so years time. This of course only adds to the complexity of decision-making for long-term investment for businesses.

In either scenario, this will still negatively impact both economies in the short run. Trade is not a zero-sum game and disrupting an existing supply chain comes with significant cost. Both sides certainly understand this so the short-term pain must have some sort of long-term gain or objective in mind.

From the American / Trump administration perspective, the long-term or ultimate objective appears to be to persuade China to negotiate and subsequently provide significant concessions on trade.

From the Chinese perspective, moving up the value chain is a critical step in being able to become an advanced, fully developed economy that can provide a high standard of living for the majority of its population. The oft-cited “Made in China 2025” plan is directly linked to this objective and includes as one of its strategic focus areas the development of a semiconductor ecosystem (including high-level design) so the economy is less vulnerable to external — and I would argue, politically driven — shocks like the ZTE ban. As such, I think there is very little negotiating room on this front for China because I do not expect it to simply give up on the goal of becoming a fully developed economy. Therefore, China really has no choice at this point than to power forward or even double down on this strategy. If it is successful in doing so, it comes out of this better-positioned than before — as we lose one of our trump cards (no pun intended) in future negotiations. If not, perhaps they do come the negotiating table at some point — perhaps by waiting it out to see how the 2020 elections go.

Glenn Luk 10/05/2018

28/04/2018

04/05/2018