Huawei and ZTE Face the Trade War Music

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According to the US House intelligence committee report, two of the leading Chinese telecom firms, the privately-held employee owned Huawei Technologies and ZTE pose a security threat to the United States and therefore the doors to the U.S. market through M&As should be closed on them while both private and public institutions are advised not do business with them. Naturally, both of the firms have denied the allegations at the U.S. panel hearing that claims that the companies are linked to the Chinese government and the military. This comes on the heels of the U.S. looking to block the CNOOC’s (NYSE: CEO) bid for the Canadian energy firm Nexen, as it has nearly 10% of its assets inside the U.S.

The congressional report’s investigation was critical of the two companies claiming that interviews of current and former employees led them to believe “Huawei and ZTE cannot be trusted to be free of foreign state influence and thus pose a security threat to the United States and to our systems."

The report comes just weeks before the all important US presidential elections in which China bashing is a hot topic as both candidates, President Obama and Mitt Romney, are looking to score points on increasing pressure on China, who is seen as the trade enemy of the growing American underclass. Earlier in October, Mr. Obama personally blocked the bid of a Chinese firm from acquiring U.S. wind farms.

The committee chairman Mike Rogers (R-Mi) thinks that the ZTE and Huawei cannot be trusted with intellectual property and consumers’ data. However, the report did not go as far to suggest an embargo on their equipment. The two companies will continue to operate in the U.S. market but the purpose of this report was to put a dent in their reputations. The portion of the report released for the public does not indicate exactly how the panel reached its conclusion. It appears that the findings, at least the public portion, are based on the interviews of ex-employees, making the report itself questionable.

Piling on the trade warfare, the U.S. Department of Commerce confirmed earlier investigations into fixing anti-dumping and countervailing duties from 18% to 250% on solar cells manufactured in China.

For Huawei, one of the largest employee owned technology firms in China, its problems stem from its founder Ren Zhengfei, a former member of the People’s Liberation Army 25 years ago. Rumors that tie Huawei to China’s military have often surfaced and was the primary reason behind the U.S.’s rejection for Huawei’s bid to acquire 3Leaf systems in early 2011. Huawei, the world’s second largest maker of router and telecom equipment, has reacted by pointing out that it earned more than 70% of their $32 billion in revenues last year from outside China and, “is not going to jeopardize its commercial success for any government, period”

Furthermore, both companies have been accused of manufacturing their equipment with codes that transmits information to their home country.  Moreover, another series of investigations revealed that ZTE sold Cisco (NASDAQ: CSCO)’s equipment to the Telecommunication Company of Iran which has prompted Cisco to end its seven year partnership with ZTE. Cisco competes directly with Huawei through ZTE in the Chinese market. China is itself a major player in global router sales. Last year, total enterprise router sales increased by 2% to $920 million but most of the growth were attributed to the 34% increase in China.

Following the news, ZTE affirmed to cut back its relationship with the Iranian firm and has denied any interference by the Chinese government. It has never made any such demands and even if it did, then ZTE, due to its U.S. operations, would obey its laws.  However, their sales to Iran put them on thin ice with the Americans.  Make of all of this what you will but while the government’s fight the companies will be caught in the crossfire.  Is this all fallout from China explicitly defying the Americans over Iranian oil sanctions? Most likely. 

It will be up to China’s new leadership which will emerge from the 18thCPC National Congress starting on November 8 in Beijing to decide the way forward. It wouldn’t be surprising if China decides to retaliate. But, every single large U.S. firm manufacturing electronic equipment, including Cisco, has got some degree of connection with China in its supply chain. Chinese media has severely criticized the US action with People’s Daily alleging that the committee hasn’t produced an “iota of evidence” to justify its actions while the official news agency Xinhua spoke about the U.S.’s “cold war mentality”.

This situation is a mess politically as tensions stoked on both sides for political gain in an election year are beginning to boil over.   China’s controversial Great Firewall - itself a massive bit of protectionism on the pretext of security and cultural differences -blocking Google (NASDAQ: GOOG), Facebook and Twitter was going to have repercussions eventually.  And with the commoditization of smartphones well underway, led in many ways by Huawei and ZTE, this move by the U.S. to protect not only Google but Apple (NASDAQ: AAPL) as well, which together account for more than 40% of the total earnings of the S&P 500, is perfectly understandable.  With Google and Apple each spending more now on IP protection than R&D this type of legal wrangling, or moat-building in a perversion of Buffett’s famous investment criteria, will only get worse as the global economy limps along under the weight of debt deflation and monetary stimulus.

Both Huawei and ZTE are world-wide operations with a presence in over 150 markets and like all other global telecom firms, they see the U.S. as one of the most attractive telecom markets.  Their presence on low-cost pre-paid carriers like MetroPCS (NYSE: TMUS) will be greatly improved by the merger with T-Mobile.  Pre-paid wireless is where the growth in smartphones is coming from and the MetroPCS/T-Mobile merger will create the biggest carrier catering to that portion of the market.  Huawei is aiming to become the third largest smart phone producer by 2015 with a 15% global market share.  Will this report fundamentally hurt their ability to do that?  U-6 unemployment is at ~15% and 51 million people are on food stamps in the U.S.  Cheap smartphones are the future not the past.  Brand building and the right price points will almost always trump political puffery.  Until the U.S. bans ZTE and Huawei from the market this is all sound and fury.

PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and Google. Motley Fool newsletter services recommend Apple and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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