Huawei: Q&A with Bailard's Eric P. Leve, CFA & Dave H. Smith, CFA

How trade tensions permeate national security, infrastructure and the smartphone in your pocket

For Q2, Eric P. Leve, CFA, Bailard’s Chief Investment Officer, chats with David H. Smith, CFA, Bailard’s Senior Vice President of Domestic Equities.

June 30, 2019

Eric P. Leve, CFA: The Chinese company Huawei has captured a lion’s share of headlines and emerged as a fundamental issue in the current trade hostilities between China and the U.S. Dave, can you give a thumbnail sketch on the company and why it’s so important?

David H. Smith, CFA: First, Huawei is massive. But being a private company, it has been underappreciated in the West and, particularly, in the U.S. As the #2 smartphone manufacturer in the world by volume, Huawei leads Apple, trails only Samsung and boasts particularly strong market share in both Asia and Europe. They lead in telecommunications equipment and are widely expected to play a crucial role in the upcoming global move to 5G cellular technology. Goldman Sachs estimates Huawei’s market share in wireless hardware at 35% in Europe, 40% in the Middle East and 30% in Latin America. They claim almost 200,000 employees and recently broke through $100 billion in annual revenue, placing at #72 on the 2018 Forbes Global 500 list, just behind Microsoft. In addition to strong technology and market share, Huawei’s growth has been strong at 39% year-over-year in the first quarter of 2019. This giant is one of the crown jewels of China. But, since 2016, the company has been a target as the U.S. has pushed nations across the globe to diversify away from Huawei’s technology, fearing that it could be a vehicle for espionage or include secret ‘back doors’ for foreign hackers. These details are important to remember as we reflect on how this situation could evolve.

Eric: That's a great point. Looking at recent speeches by members of the Trump Administration, it’s clear that the White House views China as the greatest threat to American hegemony. China is an economic powerhouse—the second largest globally—and is on its way to becoming a military one as well. When China was exporting cheap household goods, it was a boon to the U.S. consumer; now that China is supplying cutting-edge technology, it is perceived as a threat to America’s companies and intellectual dominance. China achieved this feat through hard work but also, it seems, from abusive trade practices including forced technology transfer and the theft of intellectual property. Huawei embodies this fear. As you mentioned, the company is (or perhaps, was) poised to be a primary supplier of critical global telecommunications infrastructure. Huawei is likely more than a pawn in these discussions; this latest move from the U.S. represents an attempt to cut off China from controlling 5G and slow the nation’s rise as a global technology super power. Dave, can you give us some color on the current situation and the potential impacts?

David: Of course. Huawei’s situation is very fluid at the moment, with negotiations ongoing. The broadest and most hard hitting of the U.S. actions is the addition

of Huawei to the Entity List by the Commerce Department, which was done in May in response to accusations of prohibited business with Iran. The addition to the Entity List restricts U.S. companies from selling any products or technology to Huawei. Further,

companies abroad are restricted from selling any product that contains U.S.-originated parts to Huawei. There are some exceptions, but the application of this rule is broad and includes parts as simple as pieces of plastic. In the age of modern supply chains and U.S. technology leadership the impact of this action is quite simply monumental. In many cases, U.S. firms are the world leaders and there may not be an acceptable foreign replacement. Further, sophisticated technology systems are not simply “plug and replace.” Removing a supplier from a product can shut down production and force an intensive, lengthy redesign.

The second action the U.S. has taken is an executive order that designates China as an adversary and places restrictions on the use of Chinese telecommunications equipment. At the moment, Huawei’s business in the U.S. is relatively small, but it has had some success

with smaller rural networks. This business would be at risk: indeed, the order allows the Federal government to cancel contracts already in place. The timing of this executive order is under review as rural networks plead for more time to switch away from Huawei equipment. After the G20 meeting in June, President Trump stated he would remove some restrictions. However, comments from White House economic advisor Larry Kudlow suggested Huawei will remain on the Entity List but that the U.S. government will make

some exceptions for products that pose no threat to national security. All together, these actions continue to look potent and if left in place are likely to continue to have wide-ranging impact, both on Huawei and its suppliers. Eric, can you think of a precedent for this

type of action?

The second action the U.S. has taken is an executive order that designates China as an adversary and places restrictions on the use of Chinese telecommunications equipment. At the moment, Huawei’s business in the U.S. is relatively small, but it has had some success with smaller rural networks. This business would be at risk: indeed, the order allows the Federal government to cancel contracts already in place. The timing of this executive order is under review as rural networks plead for more time to switch away from Huawei equipment. After the G20 meeting in June, President Trump stated he would remove some restrictions. However, comments from White House economic advisor Larry Kudlow suggested Huawei will remain on the Entity List but that the U.S. Government will make some exceptions for products that pose no threat to national security. All together, these actions continue to look potent and if left in place are likely to continue to have wide-ranging impact, both on Huawei and its suppliers. Eric, can you think of a precedent for this type of action?

Eric: Industrial policy can be a dirty phrase, but it is used by emerging countries to protect their nascent industries and larger countries to protect their market share. Throughout the 20th century it was a way to keep the challengers at bay. The difference this time is that the U.S. is competing with not just a radically different economic system, but a political one. These enmeshed forces in China make any mercantile loss for the U.S. feel like a political loss as well. With that in mind, Dave, how do you think about the broader impact

of Huawei on the technology sector?

David: The early pain in tech has been felt by direct suppliers of Huawei, including many semiconductor firms. Chipmakers designed into Huawei’s mobile phones and networking equipment have been forced to slash revenue and profit estimates. Uncertainty has spiked with many firms across the globe still analyzing the impact of the restrictions and determining which sales are permissible and which are banned.

Longer term, my view is that more competition results in better and cheaper outcomes for consumers, and thus any action that reduces competition will be a net negative for consumers. Huawei telecommunications products have historically been selected because of solid reliability, advanced technology and low cost, and the company’s mobile phones were highly reviewed and quite popular outside of the U.S. That said, it is abundantly clear that the U.S. intelligence agencies consider Huawei captive to the whims of the Chinese government and could be compelled to take actions against other nations. Under this worldview, the concept that this entity could be a dominant player in the backbone of the global telecommunications infrastructure market is a frightening one. To Huawei’s competitors, this ban represents an opportunity to fill gaps. The end market demand for mobile phones and 5G technology will continue to roll on. While this action could delay individual projects as companies are forced to redesign systems, our research suggests the technological solutions will be there from other technology giants.

I grow increasingly concerned about the rising hostility. Retaliation can take many forms, from an outright ban on large companies to stoking nationalist sentiment against U.S. firms. A festering wound in the relationship between the two largest global economies represents persistent risk and opportunity cost for many multinational U.S. firms.

On that note, it’s worth recalling that this is not the first time sanctions have been issued against a Chinese company. For those less familiar, in 2018 the U.S. slapped sanctions on a smaller Chinese telecommunications firm, ZTE, for its dealings with Iran. The ZTE comparison is an apt one given it was enacted, then settled by the current administration. Within 30 days of the sanctions, ZTE announced that it had ceased major operating activities, in large part because of lack of access to critical U.S. technology components. In

a surprise turnaround the U.S. agreed to remove the ban two months later in exchange for a large monetary fine, corporate restructuring and new oversight by U.S.

representatives.

The ZTE case was different in several fundamental ways. First, ZTE is significantly smaller than Huawei, about one tenth of the size. Additionally, as we mentioned earlier, there appear to be serious national security concerns about Huawei being an integral supplier of next generation telecommunications equipment; this could be a further headwind to resolution, particularly as the White House’s appeals for other nations to avoid Huawei have largely fallen on deaf ears. The last contrast I would make is that ZTE appears to have been caught unaware by the breadth of the sanctions; Huawei’s stocking of inventory may help prevent or delay a dramatic operations shutdown, although Huawei’s CEO recently projected revenues 30% below the initial target. In the end, my hope is that cooler heads prevail and that a Huawei deal can be reached with additional provisions similar to ZTE. China may still be willing to make concessions to “even the playing field” for U.S. firms, and both countries may be able to move forward under free and fair trade. Is this just wishful thinking, Eric?

A festering wound in the relationship between the two largest global economies represents persistent risk and opportunity cost for many multinational U.S. firms.

Eric: Perhaps this can still happen. It’s worth recalling that only five years ago China banned Microsoft’s Windows operating system from government use, claiming that the newest release contained a secret “back door” in the source code that could enable espionage. Microsoft claimed this code was used for telemetry and reporting data and refused to share the code. In the end, Chinese officials and Microsoft teams collaborated and reviewed code: eventually Microsoft released a special version specifically for the Chinese government that excluded the reporting functionality. China then rescinded the ban.

The stakes are much higher today for the many reasons you’ve enumerated Dave. China will make concessions mostly because in a (near) future—when it is a net exporter of intellectual capital as opposed to the importer it has been historically—it will want exactly the kinds of protections the U.S. is now pursuing. The powerful benefits of free trade among nations can be set back at times but, in the end, it is a win for all parties.