November 16, 2018
L'AQUILA -- Struck by a devastating earthquake in 2009, the Italian city of L'Aquila has still not fully recovered. Construction cranes tower above the ravaged historic buildings of the city center. Houses on the worst-hit streets are either crumbling like ricotta cheese or caged in scaffolding. It is an apt setting for this year's get-together between ZTE and its European wireless customers. Rocked to its foundations by US penalties, the Chinese equipment vendor is also rebuilding after its business nearly collapsed.
Figure 5: Much of L'Aquila was in ruins after the 2009 earthquake.
Its own earthquake is fresher in the memory than L'Aquila's. The shocks began in 2017 when US authorities charged ZTE Corp. (Shenzhen: 000063; Hong Kong: 0763) with selling US technology to Iran and North Korea, in breach of sanctions. After ZTE paid a fine of nearly $1 billion, which decimated profits for the 2016 fiscal year, the market hoped its troubles were over -- until new allegations surfaced in early 2018. ZTE had lied, said the US. Executives it was supposed to have sacked were still at the company. Corporate governance had not improved. (See ZTE in Existential Crisis as It Slams 'Unfair' US Ban, Considers 'Judicial Measures'.)
Figure 1: A church spire stands over the town of L'Aquila in central Italy.
This time, the penalty was far more severe. Banned from acquiring the US components needed for most of its products, ZTE was forced to cease operations for several weeks. That almost drove it out of business. Only after ZTE agreed to pay another $1 billion fine, replace its senior management team and be closely monitored by regulators was it allowed to resume trading. This year, it expects to rack up a $1 billion loss. (See ZTE Back in the Game, Seeking Trust & 5G Deals.)
Customers are unsettled, to say the least. One executive told Light Reading there is a "plan B in the back pocket" should ZTE fall short of its obligations. A pressing concern is the current security backlash against Chinese vendors by governments in the West. Since 2012, US authorities have been apparently worried the Chinese government could spy on American citizens and organizations through networks built by ZTE and larger Chinese rival Huawei. Australia has more recently banned the Chinese vendors from selling 5G equipment. Canada is seemingly under US pressure to follow suit. Both Germany and the UK may also be tightening the screw, according to recent press reports. (See UK Govt Warns Telcos on Choice of 5G Vendors, Australia Excludes Huawei, ZTE From 5G Rollouts, US Senators Urge Canada to Ban Huawei – Report and Huawei, ZTE Charm Offensive Just Got Harder.)
Perhaps the real surprise, then, is that more ZTE customers have not already defected. ZTE's expectations of a $1 billion loss this year are based on what happened in the first half. For the recent third quarter, it actually managed a small net profit of about $81 million. Sales fell just 14%, to around $2.8 billion, compared with the year-earlier period -- a far shallower drop than one might have expected. (See China's ZTE Expects $1B Loss This Year After US Sanctions.)
Figure 2: ZTE Sales and Profits ($M) Source: ZTE. Note: All currency conversions are at today's rate.
That some customers are loath to replace ZTE is understandable. Dropping one vendor for another is "absolutely not" easy, according to our "plan B" executive. "That is the worst-case scenario and why we follow this really closely," he said. After years of consolidation in the equipment market, the last thing operators want is the disappearance of a low-cost challenger still admired for its technological prowess. Small operators are likely to view ZTE as a necessary counterweight to the major forces of Ericsson AB (Nasdaq: ERIC), Huawei Technologies Co. Ltd. and Nokia Corp. (NYSE: NOK).
Nevertheless, ZTE's problems might spur some customers to abandon their "single vendor" strategies and introduce a second supplier as an alternative. Blaming ZTE's suspension of business activities for delays to a major network project, Italy's Wind Tre has done just that, snatching some work from ZTE and handing it to Ericsson. "Wind Tre … has given notice to ZTE Italia of a partial termination and de-scoping of its activities under their RAN [radio access network] agreement with Wind Tre," said the operator in its earnings report for the second quarter. (See ZTE ban and Iliad entry blow Wind Tre of course.)
But the multivendor approach is impractical in the smallest markets, a source tells Light Reading. This seems to explain why a company such as SWAN Mobile, the fourth mobile operator in Slovakia, relies solely on ZTE for its core and 1800MHz-based radio access networks. "Cooperation with ZTE helps us to save costs and we don't have to deal with multiple vendor networks," Patrick Kollaroci, the operator's chief technology officer, was overheard saying at ZTE's L'Aquila event.
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Right now, ZTE is bending over backward to support existing customers. Appreciating Wind Tre's dilemma, it even helped the operator to introduce Ericsson as a second supplier, says Ming Xiao, the vendor's youthful president of global sales. The tone he struck during the L'Aquila event was overwhelmingly one of contrition. "Without your understanding and support, ZTE wouldn't have the chance to stand here and to have this event," he told customers during a morning presentation. "Most of you are my friends and I hope this friendship will continue for many decades."
On the sidelines of the event, Ming Xiao acknowledged that customers had voiced concern after what he frankly describes as the "crisis." Yet the majority have retained ZTE in their footprints, he said -- an assertion that ZTE's recent financial recovery seems to bear out.
Next page: Bouncing back?
In its domestic market, ZTE can probably count on maintaining its relationships with China's big three state-backed operators. Authorities, for one thing, would rather see network business go to ZTE or Huawei than Ericsson and Nokia, a preference that may become more obvious if Western governments squeeze out the Chinese vendors. Ming Xiao is keen to emphasize the big-picture importance of the Chinese mobile market. The 1 million 4G basestations that ZTE has deployed in China represent about a fifth of the entire 4G infrastructure market globally, he says. Last year, ZTE's business in China accounted for roughly 57% of total sales. (See America Is Losing the 5G Race, Says Deloitte.)
To persuade Europeans and other customers of its staying power, ZTE has worked hard to get its business up and running after it went into hibernation mode during the US components ban. It resumed manufacturing and supply-chain operations in a matter of days after the ban was lifted, says Ming Xiao. Despite a cull of board members and senior executives, there has been no major workforce reduction at the company, which today employs about 80,000 people, according to executives. If that has put margins under pressure, it has also allowed ZTE to continue offering the same level of support to customers.
Figure 3: Ming Xiao, ZTE's president of global sales, addresses colleagues and customers in L'Aquila.
In the wake of the crisis, ZTE has ramped up its spending on research and development, too. Investments rose 37% for the recent third quarter, to nearly $500 million, compared with the year-earlier period. That figure represents about 18% of third-quarter sales, up from just 11% a year earlier, and nearly half of total R&D investments for the first nine months of 2018. It is this R&D commitment, rather than any sales-related activity, that makes the real difference in customer engagements, says Ming Xiao.
Telco executives and analysts who have spoken with Light Reading clearly hold ZTE's technology in high regard. Among other things, it is widely recognized as a leader in massive MIMO, a sophisticated antenna system for boosting performance on mobile networks. Ming Xiao boasts that ZTE has a head start of several years over some of its rivals in this area. (See ZTE, Telenet Hail Massive MIMO First in Europe.)
Figure 4: Outside ZTE's facilities in L'Aquila, the venue for its user congress and 5G summit this year.
It also now champions a virtualized core technology that can support 3G, 4G and both variants of 5G (those being non-standalone, which uses 5G new radio technology in conjunction with a 4G network, and the more comprehensive standalone system). "This is one of the most innovative applications we have," said Wang Jiayi, ZTE's director of 5G radio access networks. "We are actively testing that in China and Europe." French telecom incumbent Orange (NYSE: FTE) is carrying out standalone trials with ZTE in Spain and made a 5G call over the common core this week, it emerged at ZTE's event.
Cost competitiveness added to this technological prowess makes for a compelling proposition. Even operators that do not buy equipment from ZTE must appreciate the pressure it has put on other suppliers, as ZTE seems keenly aware. "We are the only remaining top-quality challenger in this industry," said Xiao Ming in a presentation to operators.
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But some observers are not convinced. Experts who spoke with Light Reading on condition of anonymity point to ZTE's vulnerability in what seems to be the West's increasingly hostile regulatory environment. The re-establishment of its supply chains along traditional lines means ZTE is still heavily reliant on US equipment and therefore in more danger than Huawei, which manufactures a bigger share of its own components. Another US ban might deliver a fatal blow to ZTE.
A further uncertainty is whether ZTE's third-quarter recovery is just some kind of dead cat bounce explained by a back-up in demand. Operators cannot just immediately rip and replace systems, says one expert. But they could phase out ZTE with the transition to 5G technology -- a shift that might not become apparent in Europe for a year or two. A failure to land 5G deals would translate into a slow death for ZTE outside China. Indeed, given the regulatory backlash against Chinese vendors, a distinct possibility is that ZTE retreats from some developed Western economies to focus on China as well as emerging markets in Africa and Asia.
Even before this week's event, L'Aquila had become an important location for ZTE. Around the city, it has been carrying out trials of 5G technology with partners including Wind Tre. Recent R&D spending has also gone toward a 5G innovation center that draws on the support of the local university. Paola Inverardi, its president, says one of the most important applications is an earthquake-monitoring system that would take advantage of the reduction in signaling delay 5G should bring. A system that predicts when regulators might strike is what ZTE could really use.
— Iain Morris, International Editor, Light Reading
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