U.S.'s ZTE Investigation Could Expose Other Chinese Firms

| About: Zte Corp. (ZTCOY)

By Fan Yu

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ZTE's booth at the Mobile World Congress in Barcelona on Feb. 20, 2016. (Luis Gene/AFP/Getty Images)

Chinese telecom equipment giant ZTE Corp. (OTCPK:ZTCOF) (OTCPK:ZTCOY) was hit with trade sanctions from the U.S. Department of Commerce last month for allegedly violating laws restricting exports of American made technology to Iran and other nations.

Trading of ZTE's shares was suspended for a month on the Shenzhen Stock Exchange, and is down more than 3 percent since April 7 when trading finally resumed.

The sanctions were temporarily lifted until June 30, assuming ZTE continues to cooperate with U.S. authorities. The increased scrutiny will likely expose other Chinese firms to similar bans, potentially introducing volatility and downward pressure on Chinese stocks - with the Shanghai Composite already down 13 percent year to date.

The U.S. government has been investigating ZTE's activities dating back to 2012. The company allegedly created shell entities to sell software and telecom equipment containing components made in the United States to Iran, which is in violation of U.S. economic sanctions.

On March 7, the U.S. government barred manufacturers from selling U.S.-made electronic components to ZTE. The sanction was a major setback to ZTE's global operations. The company delayed releasing its 2015 financial statements by around two weeks to assess its bottom line impact, and three top executives left the firm. Shi Lirong, CEO since 2010, and two executive vice presidents stepped down from their posts on April 5.

The case is ongoing and ZTE isn't in the clear yet. "The investigations are still in progress, and may result in criminal and civil liabilities under U.S. laws," the company announced April 6 when it released its 2015 earnings.

A Critical Case

The Shenzhen-based ZTE, China's second largest telecom company, relies on key U.S. components for much of its equipment. "In the information and communications technology sector, Chinese companies are unable to wholly rely on self-production," an equities analyst in Hong Kong told Caixin, a Chinese business magazine.

"China still lags behind in key areas, such as the production of computer chips, storage devices, electronic devices used in telecom towers and other advanced materials."

An unfavorable outcome to ongoing investigations could bar procurement of critical components from U.S. vendors such as Qualcomm (NASDAQ:QCOM) for smartphone chips and Xilinx (NASDAQ:XLNX) for base station chips, a catastrophic result for ZTE's global business.

ZTE currently has less than 5 percent global market share on mobile phones, and its latest smartphones all use Qualcomm chips. It's also a major player in networking equipment such as base stations and switches.

The investigations are still in progress, and may result in criminal and civil liabilities.

- ZTE

In a research note to investors, Nomura Securities last month estimated that between 10 and 15 percent of ZTE's components are sourced from U.S. companies. Of those components, ZTE would be able to secure alternative vendors to cover only 30 percent of its needs from U.S. companies, according to Commerce Department estimates. That means production on some products would be halted, severely crippling ZTE's ability to compete.

Huawei Implicated?

The Commerce Department released internal ZTE documents from 2011-marked as "top secret internal use only" - which detailed its plans to set up seemingly unrelated intermediary companies to facilitate exports to countries such as North Korea and Iran.

To justify the plan, ZTE analyzed similar trading structures set up by a firm with the alias F7, a competitor to ZTE. A document described how F7 had so-called "cut-off companies" to "sign contracts for projects in embargoed countries."

The document admitted that once American authorities notified Congress of F7's business interests in embargoed countries, F7's ability to do business in the U.S. was hampered. "In 2010, F7's proposal to acquire U.S. 3Leaf Company was opposed by the U.S. government, citing the impact to U.S. national security," the memo said.

The company F7 as described by ZTE sounds suspiciously similar to none other than its biggest rival, China's No. 1 telecom firm Huawei Technologies.

In 2010, the Justice Department blocked Huawei's purchase of 3Leaf Systems due to national security concerns. ZTE's documents also claimed that F7 had an ongoing joint venture with U.S.-based digital security firm Symantec (NASDAQ:SYMC). Huawei apparently teamed up with Symantec in 2008 to jointly develop computer network security products, and the alliance was terminated by Symantec in 2012 on grounds that its partnership could jeopardize Symantec's relationship with U.S. government agencies.

ZTE also described the company as a formidable competitor. "This [F7's] cut-off company's capital credit and capability are relatively strong compared to our company; it can cut off risks more effectively," the document read.

Huawei, with annual revenues of more than $60 billion, is much larger than ZTE and has a bigger footprint in the United States as a leading smartphone maker. It would be hardly surprising if ZTE sought to replicate Huawei's business practices.

The Pentagon and U.S. Congress believe Huawei has Chinese military ties, and the company has been accused of forging government documents and hacking government e-mail systems. In 2014, the Washington Times reported that Huawei attempted to breach the NSA's computer network.

The ongoing ZTE case could signal that the U.S. government is increasing investigation and enforcement of trade embargo rules. And Chinese companies, especially ones in the engineering, construction, and financial sectors could be in the cross hairs.

As early as 2010, the Washington Post reported that U.S. intelligence believes several Chinese companies and banks were engaged in exporting restricted technologies to Iran, possibly for use in its military missile program.

Beijing Aeronautical Manufacturing Technology Research Institute, owned by Chinese aerospace firm Avic, was placed on a watchlist in 2014 by the Commerce Department for its business with Iran.

While certain U.N. sanctions against Iran were eased recently, the U.S. continues to maintain unilateral economic sanctions against Iran. As of April 17, no official U.S. investigations have been announced for Huawei.

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