On April 16, the United States Department of Commerce announced that ZTE would no longer be allowed to import American technology products. This order represents a reinstatement of a previous order first issued in March 2016 and creates many issues for ZTE, its customers, and suppliers.
While there is no shortage of media coverage of the ban, Cignal AI aims to provide you with unique insight. We have assembled our observations and conclusions on this remarkable event, and we share answers to some common questions we’ve received as it has transpired.
Summary
The order as issued is permanent and bans technology exports from the USA to ZTE for seven years. As a reminder, when this last happened in 2016 a deal was struck within three weeks. Despite this historical proxy, a thorough reading the US order suggests that the US Department of Commerce is not in a dealing mood. One can’t predict whether the order will stay, or under what conditions, so our conclusions assume it is permanent.
- ZTE has no means to produce optical equipment, nor add capacity to existing systems in the field. This extends to other product lines at ZTE such as mobile phones. The company is effectively shut down.
- Many of the components ZTE requires (WSS, narrow-linewidth lasers) are sourced exclusively from the USA. There is no second source for many components especially when you consider…
- Japanese suppliers appear to be following the lead of the USA. All Cignal AI contacts in Japan indicate that Japanese companies will not supply ZTE, pending guidance from the Japanese METI (Ministry of Economy, Trade, and Industry).
- ZTE competitors Nokia and Huawei may realize marginal benefit outside of China, but ZTE had only a minor market share in EMEA (5%) – this will not be a major windfall.
- The risk to the acquisition of Oclaro by Lumentum is limited to additional delays in obtaining Chinese anti-trust approval; the merger still makes sense even with the loss of ZTE revenue.
- It is unclear if ZTE stockpiled components from suppliers before the ban, but given the speed and unexpected nature of the ban, there would not have been much time to do so.
History
On March 7th, 2016 the US Dept. of Commerce (USDOC) first announced a denial of export privileges for ZTE (link). This was a result of a USDOC investigation which concluded ZTE was exporting equipment with American technology to Iran and North Korea – actions that were explicitly prohibited in the export license agreement.
The March 2016 ZTE export ban caused a massive stir in the industry as some component companies prepared to adjust as one of their large customers was crippled. The ban was lifted only three weeks later and eventually resulted in a settlement between ZTE and the USDOC a year later on March 24, 2017 (announced March 7th, signed by USDOC on March 24th, 2017). While a surprise, the ban was short lived with only a minor effect on near-term financial results for ZTE and its suppliers.
The ban did have some lasting impact, however. Coincident with rapid growth in Chinese 100G deployments, it triggered the onboarding of excess component inventory in China during 2016 and early 2017. During the year-long suspension of the export ban between March 24th, 2016 and March 23, 2017, ZTE’s best interest was to stockpile inventory while the case with the USDOC was negotiated. Some at ZTE believed that Huawei was adding to ZTE’s pain by purchasing as many components as possible during this period to curb ZTE’s access to inventory.
The USDOC’s 2017 agreement with ZTE mandated actions the company needed to take with employees and a massive $1.2B fine. Some also cite the ban as a catalyst for China’s current movement to build more optical components domestically (see China’s 5 Year Optical Component Plan). We disagree, as companies such as Huawei were already heavily engaged in advanced optical R&D before the events of 2016.
Recent Events
This, as you know, is not the end of the story. On April 16th, 2018 the USDOC made the shocking announcement that the original 7-year export ban would be enforced effective immediately. This was a stunning black swan event. A year had passed since the ZTE settlement, and the optical component industry considered the issue resolved – so much so that ZTE and Huawei had stopped accumulating component inventory as insurance against hard times.
According to the detailed USDOC order (a must read), the USDOC cites ZTE for repeated false statements following the March 24th, 2017 settlement and failure to execute on promised personnel actions, including forfeiture of bonuses for specific employees. On March 6, 2018, ZTE’s outside counsel verified this as fact during a conference call. These false statements constituted a violation of the probation terms extended as part of the March 24, 2017 deal.
A week later, on March 13th, 2018 (the first day of OFC 2018)the USDOC notified ZTE that sanctions would be re-activated and ZTE responded on March 16, 2018. ZTE’s written response confirmed the false statements and lack of compliance. The company went on to explain that a delay was needed so it could conduct an internal investigation into why there was not a proper execution of the promises it made. The USDOC denied this delay based on the false statements ZTE had made during the year since the agreement was reached.
The order was signed April 15th, 2018; it re-institutes the 7-year export license ban from March 13, 2018 (when ZTE was first notified) until March 13, 2025. The USDOC order refers explicitly to “ZTE’s Pattern of Deception, False Statements and Repeated Violations of U.S. Law” as well as “ZTE Cover-Up Activity” (pages 6-11 of detailed order, worth reading)
Reading the order does not give one confidence that this is an issue that will be resolved quickly, if at all.
Impact
Should this ban stay in effect for an extended duration (unlike the first ban), the impact on ZTE is catastrophic. The Dept. of Commerce effectively signed a death warrant for ZTE, which cannot supply its equipment across multiple categories (including mobile phones dependent on chips from Qualcomm) without US technology.
ZTE Response
ZTE supplies 1/3rd of all optical transport equipment in China and only about 5% in the EMEA region. But the company will be impacted across all business lines, and effectively put it out of business.
Redesigning the equipment isn’t an option. We can see no way that ZTE can obtain the critical hardware and software to produce switches, routers, mobile equipment, and mobile phones. There are multiple optical components like WSS modules and tunable lasers that have no non-U.S. sources. The situation is the same for ZTE’sother businesses – control plane processors, software, FPGAs, Qualcomm chips for mobile phones. Even if a Chinese supplier used American Cadence or Synopsys design software to design chips, technically it cannot supply those chips to ZTE.
Black market activity of material magnitude is unlikely. Certainly not from the US, and even in China. No other company wants to draw the ire of the USDOC at this point.
End Markets – Who Benefits
Fiberhome and Huawei will take the ZTE business within China after a 12 month period of adjustment. Fiberhome will be the largest beneficiary as the Chinese carriers are wary of placing too much power in the hands of Huawei. It is also possible a new company emerges to replace ZTE in China.
Nokia and Huawei are the beneficiaries outside of China. It will be around 12 months before this revenue appears, and even then spending won’t return to previous levels. ZTE was only 5% of EMEA, so this is not a windfall opportunity for any one vendor.
Supply Chain – Acacia, Oclaro, Japan
As suppliers go, Acacia is hurt the most, but the company is well built to take the hit. 30% of Acacia’s business came from ZTE in 2017, but ZTE probably represented 20% of its business during 2018. More importantly, Acacia does not have large inroads at Huawei to date, and this event may pave the way for Acacia to materially supply Huawei now that it isn’t supplying its competitor. Acacia has a massive cash bulwark that will allow it to wait out the slow transition of other equipment companies using external DSP suppliers.
The risk to the Lumentum/Oclaro merger is limited to additional political barriers for obtaining Chinese anti-trust approval. China has withheld this approval for Qualcomm/NXP and Toshiba/Bain mergers for an extended period; there is no reason why there will not also be delays for Oclaro/Lumentum. ZTE was an 18% customer of Oclaro in 2017, but that number was already trending down. Lumentum acquired Oclaro for its core technology and the benefits of consolidating both businesses; the action at ZTE shouldn’t change the equation.
Japanese optical component suppliers will not sell to ZTE. Those who are saying ZTE will buy components from NEL, Fujitsu, Sumitomo are incorrect. These companies are in discussions with the Japanese Ministry of Economy, Trade, and Industry (METI), but without exception, our contacts in Japan have indicated that do not plan to supply ZTE. Many optical parts are only available from US-based sources anyway (WSS, NLW tunable lasers)
We have no information to indicate optical component companies shipped to ZTE in advance of the order. Earnings season is just a few weeks away, and the answer to this question should become evident.
The export ban will not further accelerate Chinese efforts to build components internally; it only validates the reasons China and Huawei had for already pursuing this direction. It remains a long road to technology independence, a road too long to salvage ZTE’s optical equipment business.
There will be changes to our Chinese equipment forecast during the 1Q18 Optical hardware report release cycle. The expectation is that revenue in China will drop 25% from our previous forecast for 2Q18 (seasonally a weak quarter).
Afterword
There is a lot of discussion in the industry that this action was precipitated by the larger Chinese trade issues that the USA currently is pursuing. This conclusion is lazy thinking and a classic example of correlation equalling causation.
Regardless of whether Trump was President or not, it is clear that ZTE was not following the agreement made in March of 2017. The USDOC had to take action in this situation or it would have endangered its own credibility as an enforcement of US law.
Read the full order, and one can see that ZTE was cavalier with its dealings with the US DOC. ZTE paid $892 million in fines yet failed to execute some of the most basic directives such as not pay certain employees a bonus. One quote stands out:
The provision of false statements to the U.S. Government, despite repeated protestations from the company that it has engaged in a sustained effort to turn the page on past misdeeds, is indicative of a company incapable of being, or unwilling to be, a reliable and trustworthy recepient of US-origin goods, software, and technology.
Our opinion is it is going to be a lot longer than 3 weeks before the USDOC changes its mind, if ever. ZTE won’t last a year, let alone seven years without access to American technology. It isn’t clear that the Chinese government would be compelled to defend ZTE given its basic lack of compliance with the deal it struck in 2017. There are few parties remaining that are willing to spend political and financial capital to save ZTE from itself.