Pressure Piles on Huawei, ZTE

Evidence is emerging that influential Chinese telecom equipment vendors Huawei Technologies Co. Ltd. and ZTE Corp. (Shenzhen: 000063; Hong Kong: 0763) are facing unprecedented financial and competitive pressures that will weigh on future growth -- and reduce profits in the immediate term.

The two companies have changed the shape of the international telecom supply industry in the past four years and have become known for their effective and efficient R&D processes and competitive pricing. That's resulted in stellar growth, but the global price war it created may finally be catching up with them as profit margins plunge, sources say. (See Huawei 2006 Target: $8 Billion, ZTE Reports 2005, and ZTE Makes International Headway.)

At the same time, new Chinese regulations -- being brought about by international pressure to reduce subsidies -- will reduce tax benefits, forcing the companies to live on fewer government incentives. Details about the potential impact of this emerged in a recent ZTE financial report, in which the company's tax benefits were greatly reduced.

Fierce rivals
The two companies have engaged in what one industry observer in China has termed "a suicidal price war" -- both domestically and internationally -- that is affecting the profitability of both.

That competition was evident again today (Tuesday), as Huawei announced it has won a deal as "sole winner of a bid to build an IP DSLAM broadband access and broadband bearer Metro Ethernet network" at Greek national operator OTE S.A. ZTE had previously announced several DSLAM deals with the Greek carrier. (See ZTE Supplies OTE, ZTE Wins Greek DSLAM Contract, and ZTE Lands OTE DSL Deal.)

The observer, who wishes to remain anonymous, believes the increasingly tough pricing pressure under which the duo put each other contributed to a decline in Huawei's operating profit margin in 2005, which fell to 14 percent from 18 percent in 2004, while ZTE's operating profit margin edged up only slightly to around 8 percent. (See Table 1 for Huawei and Table 2 for ZTE.)

Table 1: Huawei Key Financials, 2002-2005
All figures in US$ millions 2005 2004 2003 2002
Revenues 5,982 3,827 2,694 2,128
Net income 681 624 384 108
Cash flow from operations 708 396 385 311
Operating profit margin 14% 18% 19% 10%
Cash and cash equivalents 883 1,101 Not stated Not stated
Source: Huawei Annual Report 2005
Exchange rates used by Huawei in its annual report 2005: US$1 to RMB8.07 for 2005, and US$1 to RMB8.27 for 2004

Table 2: ZTE Key Financials 2002-2005
Figures in US$ millions 2005 2004 2003 2002
Revenues 2,700 2,651 2,126 1,350
Gross profit 934 925 726 484
Operating profit 223 216 183 128
Operating profit margin 8.30% 8.20% 8.60% 9.50%
Net income 161 159 128 88
Cash in banks and on hand 696 949 not known not known
Source: ZTE annual report
Exchange rate used to convert ZTE results into US$ is $1 to RMB8, the current exchange rate as of 18 July 2006

Huawei's annual report, audited by KPMG International , shows that Huawei's cash reserves fell during 2005 to $883 million from $1.1 billion at the end of 2004.

That competition is particularly fierce in the vendors' domestic market, which is worth billions in revenues to the duo. In 2005, the Chinese market accounted for just more than 42 percent of Huawei's total revenues of nearly $6 billion, while domestic business accounted for 64 percent of ZTE's 2005 revenues of $2.7 billion.

International competitors have also experienced the sharp end of that battle. One vendor executive noted during this year's Globalcomm tradeshow in Chicago that his company couldn't compete in China even if it offered to sell its equipment at zero profit margin.

Reports from China suggest this is having a significant impact on Huawei, and that the vendor initiated a cost-cutting program earlier this year, including a freeze on new staff hires.

Huawei denies this. "We are in a stable and healthy condition," says Huawei spokeswoman Sharon Chen in an email response to our questions. "Huawei did not specifically initiate a cost reduction program at the beginning of this year," she says, adding that reducing costs is an ongoing strategy at the company, and one that has "enabled us to become more competitive."

Chen also says that Huawei has not frozen hiring, domestically or internationally. "In fact, our workforce has consistently increased throughout Huawei’s history. Especially in 2006, our workforce has increased rapidly, and currently new recruits are joining our team daily."

In March 2006, Huawei had 40,000 staff, 10,000 of which were based outside China. In mid-2005, the company said it had "more than 30,000" staff, up from 24,000 at the end of 2004. (See Huawei Plans to Triple Euro Business.)

Huawei does admit that its gross margins are "narrowing" as technology becomes more commoditized. "As a leading player in the industry, Huawei has experienced the effects of this trend and considers it a normal industry phenomenon," notes Chen.

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materialgirl 12/5/2012 | 3:48:23 AM
re: Pressure Piles on Huawei, ZTE Wow! That was a big read. Good work. It also shows that over time, you dont' get something for nothing. That long tax tale also shows how crafty those Chinese are at maintaing appearances. They have 1000s of years of experience.
gzkom 12/5/2012 | 3:48:22 AM
re: Pressure Piles on Huawei, ZTE I read an article that said every engineer in Huawei has a portable matress under the desk in the office in order to be able to work 20 hours a day.
LaoDian 12/5/2012 | 3:48:22 AM
re: Pressure Piles on Huawei, ZTE
By all means, Huawei and ZTE are still half state owned, and may be pushed to merge by the goverment, as overlapping products and excessive competiton between them may be considered by the Chinese goverment as "waste of resources".
Ben_Stern 12/5/2012 | 3:48:21 AM
re: Pressure Piles on Huawei, ZTE "That shows how important it is to understand the differences between the western and eastern culture."

True, and apparently both companies are saving a bundle by not providing dental insurance. Not necessary in the far east culture. Otherwise their overall margins would be even lower.
multithreaded 12/5/2012 | 3:48:21 AM
re: Pressure Piles on Huawei, ZTE That shows how important it is to understand the differences between the western and eastern culture.

In china, people like to take nap in the noon. The matress is for noon nape NOT for the evening sleep.

Belzebutt 12/5/2012 | 3:48:20 AM
re: Pressure Piles on Huawei, ZTE I also thought this was a particular good article from LR.
Scott Raynovich 12/5/2012 | 3:48:19 AM
re: Pressure Piles on Huawei, ZTE Call me an optimist, but maybe this is good news?

If indeed the Chinese government responds (albeit slowly) to international trade pressure, Huawei and ZTE will be forced to operate in a more controlled, and profitable, manner. If subsidies are indeed rolled back, I imagine that they will have to slow price cuts, and possibly, in the end, firm up their pricing.

This combined with more consolidation should eventually return the industry to a more stable state. Yes?

razeredge 12/5/2012 | 3:48:19 AM
re: Pressure Piles on Huawei, ZTE It is a good article. But would this story/scenario not apply to any new vendor entering new markets?

A new vendors success will be met, in time, by competitors as they adjust to defend market share, which in turn puts pressure on everyone (how about an article on Nortel's financials?).

Every vendor feels the squeeze, driving the vendor consolidation we see. As this unfolds, prices will increase, as will profits for vendor survivor profits.

My guess is Huawei will be one of the few survivors. JMHO

Peter Heywood 12/5/2012 | 3:48:18 AM
re: Pressure Piles on Huawei, ZTE Although this article points to some evidence of price competition getting less severe in Europe this year, the poll on pricing that we've been running in anticipation of this story shows the reverse - more people say price competion has got tougher than softer this year. See:

tty 12/5/2012 | 3:48:17 AM
re: Pressure Piles on Huawei, ZTE In my knowledge, Huawei is almost 100% private; ZTE is about 1/3 owned by state.

It may also explain why Huawei is more competitive.
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