Editor's Note: On the next two pages you'll find an excerpt from Chapter 13 of a new book by telecom veteran Jon Pelson called Wireless Wars: China's Dangerous Domination of 5G and How We're Fighting Back.
It's a book about the rise of China's Huawei and the effect the company has had on the global telecommunications industry. It also goes into great detail about the security threat the company allegedly poses to network operators and global governments.
Huawei has wholly rejected such claims. Perhaps the company's clearest and most detailed counterargument is contained in its many filings with the FCC. In general, Huawei argues its equipment does not pose a security threat, and that it is not a cover for Chinese espionage.
Nonetheless, the Trump administration and now the Biden administration have taken a different view, and have worked to block Huawei's business in the US and globally.
Thus, Pelson's new book is noteworthy in that it takes a broad view of the topic and provides a wide range of details about Huawei's meteoric rise in the global telecommunications industry. This selection from Pelson's book – Chapter 13, "Sizing Up Huawei and the Global Marketplace" – details the mechanics of that rise.
Light Reading is publishing this excerpt with permission from Pelson, and because it's interesting. Pelson – a former executive of telecom companies including Lucent and Sprint – is clearly an insider and clearly has his own opinion of why and how Huawei came to power. The book is already in publication and what follows is his analysis and his publisher vetted the material, not our editors. We think you'll agree that it does make for interesting reading.
Enjoy.
Next Page: Sizing Up Huawei and the Global Marketplace
Sizing Up Huawei and the Global Marketplace
"For less than the cost of an aircraft carrier, China's subsidies to Huawei wiped out the greatest source of technology innovation in America – and perhaps the world." – Anonymous, a former executive at Lucent/Bell Labs
How were well-meaning companies so vulnerable to making what seemed to be bad choices when it came to national security? The problem BT and others faced was that the benefits of choosing Huawei were real, measurable, immediate, and accrued to the buyer. The risks of making that choice were vague, unmeasurable, distant, and accrued to others. This explains why Huawei's pricing was so hard to resist.
But it doesn't explain how their pricing could be so much lower than anyone else in the industry. There are cases where a vendor may have a special product that allows it to charge a premium – while that advantage lasts – and situations where a company comes up with a unique approach that enables significant costs savings – again, while that approach remains unique. But the range of prices submitted in response to any request for proposal is generally pretty narrow.
Within a geographic market, everyone pays their scientists about the same salaries. Salespeople work off similar commissions, based on the selling region not the home country, and they move frequently between companies (providing additional insight on competing price ranges). Rental rates and electricity costs don't care who's in the building, and costs for raw components are well known and fairly level, with those components typically sourced from common vendors.
In the global marketplace, companies take advantage of the strengths of each market: software from India, hardware and assembly in China, systems integration and network engineering from Europe and the United States. It is a myth that Chinese products have a cost advantage because of the cheap labor in China; the factories of Nokia and Ericsson are in Shenzhen down the street from those of Huawei and ZTE. The result is a fairly flat cost range between vendors, with pricing moving up a little if a vendor has a unique capability and down when they are hungry to win the business. The calculus comes down to how hungry a vendor is to win a deal. As a result, bids tend to vary mostly by each company's willingness to give up margin to win.
This raises important questions about the prices that Huawei used to grow its share around the world. In many markets, when a vendor has a particularly strong desire to secure a contract, prices can approach what is technically considered "dumping," a dirty-sounding word but not necessarily an illegal practice, where a project is bid at a high enough price to cover marginal cost (e.g., cost to build the equipment, cost of installation and service), though not enough to make a profit when a vendor takes into account the cost of R&D, corporate overhead, and other indirect costs. These aggressive bids aren't sustainable – if every bid always just covered marginal cost, a company would slowly go bankrupt. But they help buy share in important markets or establish deployments that might showcase a new product. Call it a marketing investment.
Huawei's pricing with BT and others didn't look like a marketing investment. In bids throughout the world, as competing vendors submitted quotes within a few million dollars of each other, taking hits to their profit margins, Huawei was coming in with prices that didn't seem to make any sense. In some cases, the bids were so low they didn't appear to cover the out-of-pocket costs of third-party gear, like the heating and cooling equipment all companies have to buy from GE or other makers, let alone the vendor's network equipment.
Lucent's [former CEO] Pat Russo remembers a competition her company participated in to build out a network in Southeast Asia. "We bid," she says. "Nortel bid. We later learned that we were about a million dollars over them, at $23 million. Then Huawei came in at $10 million." A bid like that didn't qualify as dumping – it couldn't have covered even the marginal cost on the project. This may sound like sour grapes from a company that was getting its butt kicked around the world by the better, cheaper, harder-working upstart from China. After all, how could a company based in the United States compete with Chinese labor costs? But by then, Lucent was already taking advantage of the same low-cost labor in Asia, assembling many products in China, and incorporating many more low-cost components into the devices they assembled in other parts of the world. By the mid-2000s, virtually every network equipment maker was erasing China's cost advantage with their own China-based manufacturing.
These inexplicable quotations were widely confirmed throughout the industry, including by carriers with no ax to grind, who were all too happy to take advantage of the aggressive pricing. One executive, the former president of a major US carrier, recalls a wireless project he worked on with a non-US carrier. "The Huawei bid was so low," he explained, "that the other vendors said, 'We couldn't possibly match that. Our cost of the parts is higher than their bid.' No one could compete with them." That is, Huawei appeared to be selling with no profit margin, not even covering the costs of making, installing, and supporting the equipment. While they didn't win the business out of political concerns, the carrier issuing the contract did return to the other competing bidders and ask them to sharpen their pencils and submit more aggressive pricing. They complied.
So even when they lost, Huawei destroyed their competitors' ability to make money, reducing their profit margins and crushing their R&D budgets.
Huawei's pricing strategy effectively made their Western competitors' products worse. And it was brilliant in its simplicity. Huawei entered bids for every contract they could, everywhere in the world. They bid at prices they knew their competitors couldn't match, at least not profitably. When they won those bids, they denied their competitors the revenue from the win. But when they lost, the pressure to come in aggressively against Huawei, and the requests to lower their "best and final" pricing that the winners invariably received, wiped out their competitors' profit margins.
Huawei was destroying its competition simply by showing up.
There was just one problem with this bid-below-cost strategy: There was no way Huawei would be able to sell products for so much less than the rest of the world without eventually liquidating the company. The losses would have amounted to billions of dollars a year, enough to wipe them out in no time.
Yet, according to their reported financial results, Huawei was growing in all metrics: revenues, profits, R&D budgets, margins. The seemingly impossible pricing became Huawei's hallmark throughout their breakaway growth, with suspicions continuing about how they could bid below cost for decades and still report profits and pour billions into new investments.
Years later, Samsung's executive vice president, Woojune Kim, responding to a question in a 2020 session before a British parliamentary committee, would testify, "We have frequently seen bids that do not seem to make sense in the pricing. No company beholden to shareholders and to make profits could offer that sort of bid." Kim went on to explain that Samsung, which is one of the few electronics manufacturers in the world larger than Huawei, was highly efficient in sourcing and assembling gear, but even his company couldn't approach a cost basis that would let them compete with Huawei, and that such pricing was "not sustainable."
Huawei's own government affairs team released a study they commissioned by a researcher named Dan Steinbock that compared anti-Huawei rhetoric to McCarthyism and boasted that after Huawei entered European markets, "profit margins plunged to 30–35%, which supported consumer welfare… " It was an odd combination of a boast and an admission. Reports from the European equipment suppliers support the claim that their margins had been destroyed by Huawei's aggressive pricing.
It can't be argued that Huawei was able to do this because, as a private company, they didn't have any shareholders and weren't worried about making profits. The need for profits isn't some capitalist construct that doesn't afflict private companies or businesses in communist countries. Profits for any company are the source of investment; they fund R&D, sales force expansion, training, and everything else that enables a company to grow. The only reason a company like Amazon was able to experience rapid growth for years without turning a profit is because they kept drawing on massive infusions of capital from investors who believed in their model and knew that someday they could ease back on the growth and let the profits roll in. By the time Amazon finally hit that point in 2001 and reported their first profit, they had consumed a staggering $2.8 billion in losses, funded by those investors.
Huawei may have burned through more than $75 billion.
Next Page: The Deepest Pockets
The Deepest Pockets of All
The Wall Street Journal thinks they figured out how. In a report published in December of 2019, a team of researchers at the Journal concluded that Huawei had received $75 billion in state support during its rise to world dominance, allowing the company to undercut rivals' pricing and still pour billions into R&D. The company received more than $3 billion in outright grants and land discounts, most of those since 2008, and enjoyed $25 billion in tax incentives. Huawei insists that they received only "small and non-material" grants, many of which were available to others. Founder and CEO Ren Zhengfei even told the BBC in an interview that his company received no government grants whatsoever, a claim his PR department was forced to walk back, acknowledging that, as their own annual report described, the company received significant preferential treatment and financial consideration.
The Journal found that Huawei had assembled the land for its massive new campus through uncontested auctions where they paid as little as 10 percent of the comparable market price, saving billions of dollars. The Journal also says that the mayor of Shenzhen acknowledged as much at a state conference in 2012, saying that "local officials began waiving or reducing levies on Huawei… in the early 1990s."
But don't all countries provide support to local industries, especially those deemed vital to national security and economic health? Aren't these arrangements comparable to those offered to Western "national champions"? Not within orders of magnitude. For example, from 2000 to 2018, Cisco received a total of $45 million in state and federal subsidies, loans, grants, and guarantees, according to the Journal's analysis – still less than 0.1 percent of the aid reportedly given to Huawei.
A December 2000 article by Bruce Gilley in the Far Eastern Economic Review reported that, in 1998 alone, the state-owned China Construction Bank lent Huawei nearly $500 million in buyer's credit. A lot for Huawei, but a staggering amount for the bank; it represented 45 percent of the bank's total credit for the year. Hardly a classical diversification strategy for a bank, and not one you might expect from an institution that wasn't even focused on telecom deals. But when the Party calls… Regardless, it was a drop in the bucket compared to what the Chinese government was prepared to provide to Huawei. Wall Street Journal research says that in the years after 2000, Huawei received more than $45 billion in loans and other support from many state-run banks, all under the control of the CCP.
These loans, in particular, would enable Huawei to create a machine that pushed their products out to telecom companies all over the developing world and win 3G, 4G, and 5G contracts across Europe and Asia.
Figure 1:
Huawei's founder Ren Zhengfei.
(Source: World Economic Forum on Flickr CC2.0)
Why Complain?
Why didn't the regulators and government authorities in the United States and Europe stop the damage from Huawei? Why did they allow the Chinese company to sell their gear in the US, and all over the world, at prices that were clearly below cost, low enough to take business from most competitors, and so low they destroyed the margins on competitors who had to slash their own prices to win the business? Shouldn't countries prevent foreign companies from entering and dominating their markets, selling products below cost? And shouldn't countries put up trade barriers to block foreigners if their home country doesn't also open its markets to imports?
This is often the response from governments, whether in the Americas, Europe, or elsewhere. Leaders come to the aid of domestic industries, decrying unfair competition. Companies under threat try to position themselves as "strategic," and warranting protection. Somehow, the truly strategic telecom sector failed to earn this designation. But should any sector block foreign suppliers, even if those suppliers are selling their products at unreasonably low prices?
There aren't simple answers to these questions, says Mike Munger, an economist and former chair of the department of political science at Duke University, where he continues to teach political science, public policy, and economics. He argues that trade deficits aren't a problem, and he makes the case for continuing to trade even when a partner subsidizes their products and puts up barriers to yours.
"My trade deficit with Kroger's supermarkets is gigantic," he deadpans. "I buy a ton of groceries from them and they never buy anything from me. The last time I tried to sell them some of my stuff, they called the cops."
Munger says that if one party has something of value and the other party has money they want to exchange for it, no voluntary exchange is bad. The reason he gives the store his money is because Kroger can deliver food to him cheaper and better than he can produce it himself. In business schools, this is called the "make or buy" decision: never make anything yourself if you can buy it from another source for less. Munger instead chooses to focus on his core business, teaching classes and publishing books and papers. If he spends time making other things, things he could have purchased on the market, he's losing money. If he didn't already realize it, the market is telling him that society values his abilities as a professor more than his ability to churn butter or make his own shoes.
If Huawei sells us gear cheaper than we can make it ourselves, we ought to buy that gear and let our competing companies get into a different business, Munger argues. We would avoid expending labor creating something of one value and instead acquire that thing for less, freeing up our labor to create something more valuable.
"The division of labor is the only source of wealth the world has ever known," he says. "Wealth is the result of me specializing and you specializing: the total amount of stuff produced increases."
What if the company, or country, selling it funds those sales at prices below its own actual cost?
"Well, more power to them. That's terrific. If Kroger subsidized food to make it cheaper for me, I'd thank them." In effect, when the Chinese government funds Huawei's exports, that is a tax on its consumers and citizens and a transfer to America's consumers, who get stuff more cheaply.
And what if a company is just selling things cheaply so they can drive everyone else out of business and jack up the price? Munger explains that the math is clear that it doesn't make sense to do this. The up-front cost to sell so cheaply is typically too high for a company to earn it back through excess prices after they have become the last man standing. Other companies will just reenter the market if they see an attractive price environment, preventing the first company from reaping those excess profits. China subsidizing its exports to undercut our companies hurts its citizens and transfers the money to ours, and it can't expect the move to pay off, at least not economically.
Munger says that this process may not make economic sense for China, but that's their problem. Maybe it gives them an industry that they think they need. And China blocking our imports? Sure, it's better for us and them if they let us compete freely, but we would only make it worse if we created our own barriers too. Blocking or limiting American equipment vendors hurts China's companies and citizens, who get less choice and may have to pay more because of the restricted competition. But, again, that's not our problem.
Munger continues, "You might say, 'But China benefits from this more than we do!' That's fine. It means China's wealthier and it's likely to (eventually) start buying more US exports, because if it has more money, it won't be so export focused." In other words, wealthy countries consume more, and that means they should, eventually, import more. "If you look at South Korea, Japan, even Germany, who used to only focus on exports, they started buying iPhones and software and a lot of things that the US made once they became wealthy."
But then Munger pauses. "This is how free trade is good and creates wealth," he says, "but only provided that you take a liberal worldview that we're all in this together." This model of wealth creation only applies when you're dealing with trading counterparts, where the relationships are long term and the tone is primarily cooperative. As long as you get wealthier, you shouldn't really care if your counterpart gets even wealthier than you. It's only in a time of war that you refocus from absolute wealth and power to relative wealth and power vs. other countries.
Now, if Kroger's plan were to undercut all other supermarkets until they went bust, then suddenly cut off the food supply and starve everyone into submission, that wouldn't be a very good business plan. It wouldn't make much economic sense to harm their customers, and they would lose a fortune subsidizing the food long enough to destroy their competitors – more money than they could ever make back price-gouging later – but they would certainly gain power over their customers, far more than a grocer might typically have.
And that would be an entirely different story…
Wireless Wars copyright © 2021 Jonathan Pelson.
Reprinted with permission.