Espionage has also played a critical role in foreign policy for centuries. From the Roman Empire to the Cold War, nations have employed spies to get a better idea of what other nations are planning. In today's world, means of espionage have evolved alongside with technology with cyber-spying and hacking playing a key role in the modern security and intelligence apparatus. It has been an open secret that the U.S. and China use cyber technology to spy on each other, but issues are typically resolved behind closed doors given our economic interdependence. However, on Monday, there was a serious escalation between the two countries, which could seriously hurt US tech companies like Cisco (NASDAQ:CSCO) and IBM (NYSE:IBM).
On Monday, the U.S. announced criminal charges against five members of the People's Liberation Army who work at its cyber arm (details, including China's reaction, available here). This is the first time the U.S. has charged foreign officials for cyber crimes, alleging these individuals hacked into U.S. companies like Alcoa (NYSE:AA) and US Steel (NYSE:X). Irrespective of the merits of these charges, it is unsurprising China was outraged, arguing this decision "seriously violated norms governing international relations and for seriously slandering the image of the Chinese army." As a consequence, China summoned the U.S. ambassador, Max Bacucus, and other officials to discuss this development.
This action is a sign that tensions between the U.S. and China over cyber warfare are reaching a boiling point. In 2013, China and other nations were troubled by documents that Edward Snowden leaked about the NSA. As a consequence, China urged its companies to use domestic companies rather than American ones for hardware purchases, which led to significant market share losses for U.S. tech firms. For instance in last year's third quarter, IBM saw a 40% drop in Chinese hardware sales (IBM's financial and operating data available here). Cisco's had not been hit as badly but was seeing double-digit declines as well (Cisco's financial and operating data available here). China's pivot to domestic tech suppliers has hurt American tech firms, almost shutting them out of this major growth market.
Now, numbers have been improving lately. While IBM and Cisco have still been reporting year over year declines, the declines are getting less bad, which suggests China was allowing firms to use U.S. suppliers once again. These charges though could give China second thoughts. An increase in tensions will likely lead China to avoid U.S. tech firms whenever possible. Another piece of news on Monday will also likely make China more concerned about the NSA.
Cisco CEO John Chambers sent a letter to President Barack Obama asking for him to rein in the NSA after photos surfaced showing the NSA intercepting Cisco equipment and installing surveillance software (details available here). By doing this, it becomes easier for the NSA to spy on China. This has been a major reason why China has been hesitant to rely on U.S. tech firms. Even though Cisco and others have not been cooperating with the NSA, their equipment may be intercepted anyway. Mr. Chambers sent this letter because he realized how damaging the news could be. If China thinks Cisco equipment has NSA software, it will avoid Cisco when possible.
News like this is terrible for U.S. tech firms trying to build businesses in China, Russia, and other emerging markets. In 2013, China moved away from U.S. tech firms, fearful the reliance created a security weakness. The news on Monday, criminal charges and Mr. Chambers' letter, will only increase the reluctance to use U.S. hardware. As a consequence, I expect China to continue to be a headwind for U.S. tech firms, in particular IBM and Cisco. Last year, IBM was hit disproportionately hard, and this news could be extremely bad for Cisco.
Investors should look at CSCO and IBM as plays only on developed markets, which are showing solid improvement. Investors looking to benefit from China's growth will be disappointed in these companies because of geopolitical headwinds. Now, neither stock is particularly expensive and have strong businesses in developed markets. For instance, Cisco is trading around 9x earnings excluding net cash and can trade towards $28 without any boost from China. Consequently, I continue to be bullish on Cisco, and prefer it to IBM because of this valuation. However, investors must be conscious of geopolitical headwinds in China that will likely lead to market share losses in the country. Investors looking to make money on China simply have to look elsewhere.
Disclosure: I am long CSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.