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TELECOMS: What’s Next After Resolution of ZTE Case?

Bottom line: ZTE will experience fallout from its run-in with Washington through much of next year, and could see an even longer-term hit to its global business as international customers start to look for alternate suppliers.

The saga of embattled smartphone and telecoms equipment maker ZTE (HKEx: 763; Shenzhen: 00006) appears to be nearing an end, as trading resumed in the company's stock following an official settlement with Washington over  illegal sales to Iran. The ending to this story certainly came with a big climax, with ZTE shares plunging by 42 percent in Hong Kong on the first day after trading resumed.

They fell by a smaller 10 percent in China on Wednesday, but only because China places a 10 percent limit on daily rises and declines in individual stock prices. Not surprisingly, the stock was down another 10 percent in China on its second day of trade, while the Hong Kong shares did a dead cat bounce and were up slightly.

The bottom line is that this whole case casts a huge shadow over ZTE, and will likely weigh on its stock and perhaps the stock of other Chinese companies dependent on foreign technology for months or even years to come. I'll come back to the longer term outlook at the end of this post, but first let's quickly review how we got to where we are, including the latest developments in this case.

It all began quite a while back when ZTE sold equipment that contained U.S.-made components to Iran, which violated U.S. sanctions at that time aimed at curbing Iran's nuclear program. Washington initially banned ZTE's U.S. suppliers from selling to the Chinese firm for seven years in 2016. But then it relented and reached a settlement allowing ZTE to pay a large fine and take remedial action to avoid the more severe punishment. It was found earlier this year to have violated that initial settlement, which touched off this latest crisis that has made global headlines.

The latest headlines show that ZTE was fined $1 billion, and forced to put another $400 million into an escrow account in case it doesn't follow through with this latest settlement. (English article) But perhaps even more severe is the requirement that the company change most or all of its senior management, and also all of its board, and that it station a US-designated compliance officer at the company.

This kind of intrusive remediation by a foreign government is quite unprecedented for a company of this size in my experience, but isn't completely unjustified. Chinese companies are famous for signing agreements, only to violate those same agreements either outright or perhaps in spirit by finding loopholes.

Bad Behavior

The fact of the matter is that the violations of the earlier settlement that the U.S. cited were relatively small, involving ZTE's failure to properly discipline employees involved with the illegal sales. I viewed one video clip of US Commerce Secretary Wilbur Ross talking on the matter, and could sense his frustration as he talked about how ZTE repeatedly lied and was evasive when confronted about the violations of the original settlement.

From that angle, this settlement certainly seems to send a strong signal to Chinese companies that they need to live up to their agreements and behave according to global standards, at least when they do business abroad. The fact of the matter is that they should also adhere to such standards when doing business at home, though that may take a while still. China's corporate culture is still quite young, around 30 years old to be exact, and in many ways looks like the U.S. landscape in the early industrial era when snake oil salesmen and exploitative businesses were quite common.

As to what's next for ZTE, this settlement could really deal a serious blow to its business going forward, even as it's allowed to live. If I'm a customer of ZTE, I would probably have serious doubts about potential future business disruptions and probably start looking for alternate vendors. The big Chinese telcos are unlikely to abandon the company anytime soon, since they do much of their buying based on government directives aimed at supporting the domestic industry.

The good news is that ZTE still derives the majority of its revenue from the domestic market, about 57 percent to be exact, according to its latest annual report. But all the uncertainty, including the chaos certain to follow with the massive management overhaul, is almost certain to cast a pall over ZTE's business for at least the rest of this year, and quite possibly well into 2019. 

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