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Company in focus

ZTE's less-known roots: Chinese tech company falls from grace

Transparent image masks large military-linked corporate background

TOKYO -- Chinese telecommunication equipment maker ZTE finds itself in a new, and undoubtedly uncomfortable, position: It is one of the most talked-about tech companies in the world following its recent ban by the U.S. government from purchasing American technology.

In China, however, where free speech is limited but with almost 800 million internet users, the home-grown company appears to be gaining a wide range of support as most stories and comments from news media and netizens take on nationalistic overtones.

Among the comments: "I believe in ZTE" and "Why can't we penalize Apple? Can't we stop Apple from selling in China?"

Another online user said: "We even made atomic bombs ourselves under much severe technological blockade when we were under poverty and blankness. As we are making giant strides in science and technology, why can't we produce our own chips that are just a size of a thumbnail?"

The remarks are just a few of the many such online comments, and they do not represent the whole picture. Even though ZTE was slapped with a seven-year ban on buying American technology components and a heavy fine for repeatedly deceiving U.S. authorities over its illegal dealings with Iran and North Korea, the moves by Washington are typically depicted at home as a national technology treasure being unfairly treated by a foreign government and that retaliation has been insufficient.

Shenzhen-based ZTE traces its origins to 1985 when it was established as Shenzhen Zhongxing Semiconductor, a joint venture involving mainly subsidiaries of the then-Ministry of Aerospace Industry. The company is seen as a frontrunner in many ways in China, along with its hometown rival Huawei Technologies. And while ZTE has yet to become a household name, it is one of the first Chinese high-tech companies to successfully make inroads into the global market with its own branded products.

The ZTE name itself has special significance. It takes the first letter from its Chinese name, Zhongxing, meaning "China to rise and prosper," combined with the company's business, telecommunications equipment.

The ban and an additional fine follow a settlement with the U.S. government in March 2017, when ZTE pleaded guilty to illegally shipping items of American origin to Iran from 2010 to 2016 in violation of U.S. sanctions. It agreed to $1.19 billion in penalties and a suspended denial of export privileges.

Following the latest move by Washington, Chinese Commerce Ministry spokesman Gao Feng stressed at a press conference in Beijing on April 19 that the government "is always ready to take necessary actions to protect legal rights and interests of Chinese companies." The next day in Shenzhen, Yin Yimin, chairman of ZTE, explained the company's position to selected media outlets and stressed that "we have the ability and the will to tide over this crisis. We are definitely not going to give up."

The company's revenue last year was 108.8 billion yuan ($17.2 billion) with net profit of 4.56 billion yuan -- mainly by selling telecom equipments and software to carriers, developing information and communication solutions for governments, and providing smartphones for retail consumers. ZTE generates 43% of its turnover from abroad, since the company first tip-toed on the global stage at a telecom event in Geneva in 1995. The company now ranks fourth in the global mobile-infrastructure market, with a 13% share last year, behind Huawei and two Nordic titans, Sweden's Ericsson and Nokia of Finland, according to researcher IHS-Markit.

Former ZTE Chairman Hou Weigui was an engineer at a Ministry of Aerospace Industry factory when he was assigned to manage the precursor of ZTE in 1985. (Photo by Kenji Kawase)

Hou Weigui, a former engineer at a state-owned aerospace company, was assigned to lead the precursor to ZTE and remained as chairman until March 2016. He boasted of his success in globalization more than a decade ago by referring to the "ZTE model."

In an article he wrote for The Economic Observer, a mainland Chinese newspaper, in March 2006, Hou attributed ZTE's achievements to roughly three elements: taking a gradual approach for developing economies, being innovative, and the qualitative transformation of the company. At that time, he vowed to gain a major foothold in developed markets and "to enhance our brand value."

Unlike Huawei, ZTE is a publicly traded company. It was listed in Shenzhen in 1997 and in Hong Kong in 2004.

As is its practice, company representatives do not publicly mention Huawei by name, but its dual-listing has been a source of difference between the two and a polished image abroad. As of February, about two-thirds of ZTE's outstanding shares are in the hands of more than 318,000 shareholders, including BlackRock and other non-Chinese investors.

But a closer look at ZTE's ownership structure sheds a different light on the company. ZTE is part of the top two state-owned enterprises in aerospace with strong links to the military -- China Aerospace Science and Technology Corporation (CASC) and China Aerospace Science and Industry Corporation (CASIC).

ZTE's latest annual report indicates that its direct top shareholder is Zhongxingxin, which owned 30.34% at the end of last year. That company in turn is jointly owned by four shareholders, two of which are state-owned, Xi'an Microelectronics and Aerospace Guangyu, and both are indirect wholly owned subsidiaries of CASC and CASIC, respectively.

Both CASC and CASIC are classified as "central companies," meaning strategic large-scale state-owned enterprises under the direct jurisdiction of the cabinet-level State-owned Assets Supervision and Administration Commission of the State Council, or SASAC. As the commission states on its official webpage, "The central companies are the main force among our state-owned enterprises." China has 97 of these central companies, and CASC and CASIC are ranked No. 2 and No. 3, behind only China National Nuclear Corporation, underscoring their importance to the government.

Central companies act in concert with the Communist Party of China and the state. Wang Changshun, chairman of China Southern Air Holding, last month criticized Washington's "unilateral trade action," saying that "being a central company, we staunchly support the central government taking all sorts of measures." Wang, speaking as chairman of subsidiary China Southern Airlines, which is dual-listed in Hong Kong and Shanghai, said his company will maintain a "high degree of uniformity with the central party committee with comrade Xi Jinping as the core."

The similar names and acronyms of CASC and CASIC, while sometimes confusing, reflect their origin as a single government entity, which traces back to October 1956 to the Fifth Academy of the National Defense Ministry, which was assigned to study and develop guided missiles.

The first head of the academy, Qian Xuesen, was an iconic scientist at home for his significant contributions to China's guided missile, rocket and space development projects and is considered the father of those fields. Qian, who was born in 1911 in Shanghai, obtained a doctorate degree and a teaching position at the California Institute of Technology during and after World War II. Qian and the academy laid the foundation for China's aeronautics and weaponry systems, even after the Soviet Union withdrew its assistance and commitments in the 1960s after a political rift between the two communist powers.

Going through a series of organizational transformations and name changes, CASC and CASIC were established in 1999. The original entity and the two successors have been the main driving force responsible for developing a series of defense systems, including the mid- to long-range Dongfeng missile, the Changzheng rocket, the Dongfanghong satellite, and atomic and hydrogen bombs.

CASIC has a 14.5% stake in Zhongxingxin, while CASC's stake is 34%, and both stakes are through their subsidiaries. According to ZTE's annual report, CASC is listed as a major shareholder -- in effect controlling 30.29% of ZTE -- and Deputy General Manager Zhang Jianheng sits on the telecom equipment company's board.

Investors were reminded of ZTE's connection to CASC and CASIC unexpectedly on April 22 with a report by SASAC's research center titled, "ZTE's Series of Reactions Were Profoundly Foolish and Passive," posted on Sina.com and other websites.

The report sharply criticized how ZTE dealt with the U.S. ban, saying the company "lied when it was first caught, lied under probation, and lied again under the observation period," and subsequently "the sword of Damocles hanging over ZTE's head eventually fell on top of it."

The statement echoed what U.S. Commerce Secretary Wilbur Ross said on April 16: "ZTE made false statements to the U.S. government when they were originally caught and put on the entity list, made false statements during the reprieve it was given, and made false statements again during its probation."

The author of the report, Wang Jiang, the research center's special project leader, further pointed out how ZTE's folly could bring about "dangerously high" risk to central companies as a whole. Wang stated that Beijing needs to be prepared for possible collateral damage "since ZTE is a subsidiary of a relatively sensitive military industry conglomerate."

The report went viral as it was shared to other sites and web media reporting on it, but it was taken down in mainland China by the next day, while still floating around websites abroad.

The authenticity of the report is unclear, but Wang has written a number of papers on topics related to state-owned enterprises. Online writers have suggested it could be a policy advisory for internal circulation purposes but found its way briefly on the internet, just enough to be noticed, and a possible indication of the government's wrath against ZTE.

Both SASAC and ZTE have not responded to requests from the Nikkei Asian Review for comment on the document.

Questions surrounding ZTE's and Huawei's businesses in the U.S. have been swirling since 2011, before the case of ZTE's illegal exports to Iran surfaced in 2012 and long before President Donald Trump took office.

A bipartisan U.S. House committee on intelligence initiated an investigation into the two Chinese telecom vendors to look into the possible counterintelligence and security threats they posed. The committee's report in October 2012 recommended the U.S. government should view the Chinese companies "with suspicion" and that U.S. telecom carriers are "strongly encouraged to consider the long-term security risks associated with doing business with either ZTE or Huawei."

In a separate report compiled for the U.S.-China Economic and Security Review Commission in March 2012, U.S. defense company Northrop Grumman said the "IT sector in China can be considered a hybrid defense industry, able to operate with success in commercial markets while meeting the demands of its military customers." ZTE, Huawei and another Chinese state-owned peer, Datang Telecom Technology, were described as playing a key role.

Given the military and technology background reports dating to the time of the Barack Obama administration, critics and analysts take a broad view of the matter.

"A lot of what we're going to see over the next couple of months will target much more directly [on] nontrade areas that have to do with technology transfer and investment," said Arthur Kroeber, founding partner and head of research at Gavekal Research, on an April 17 conference call. He also pointed to the upcoming competition for the next-generation mobile-telecom system.

"I think the timing of this is significant, because it is also at a time where the U.S. is increasingly concerned that ZTE and the other Chinese telecom company, Huawei, are stealing a march in the development of 5G technology, the next generation of technology for mobile phones," he added. "And so I think there probably is a desire to try and do what can be done to retard the progress of the Chinese firms in that."

According to media reports on April 25, the U.S. Justice Department is probing Huawei on allegations of violating trade sanctions against Iran. Huawei said in a statement the following day that it has been complying with "all applicable laws and regulations where it operates."

Liu Yongge, a professor at Toyo University in Tokyo who specializes in Chinese business, told Nikkei that "ZTE's breath could be stopped in a year, not even [the penalized period of] seven years."

However, Liu reckons that the Chinese company will survive, as "the issue is no longer in the hands of ZTE. It is now a matter of China and the U.S. governments." He expects Beijing to lend it a hand given the position it has in the local telecom equipment market.

But the much bigger issue, according to Liu, is Washington's effort to thwart Beijing's "Made in China 2025" initiative to ambitiously upgrade Chinese industry, in order to maintain a technological advantage over China. At the same time, he said, "this was a strong wake-up call for the Chinese government" and that nurturing its own chip industry will be its top priority.

Meanwhile, trading in ZTE shares in Hong Kong and Shenzhen have been suspended since April 17. The company "has decided to take certain actions" under U.S. laws, ZTE said in a statement on April 25, and the trade suspension will remain indefinitely.

However, asset managers are starting to discount the value of ZTE shares that they hold in their funds, in compliance with the guidance of the securities regulator. Shanghai-based Zhong Ou Asset Management, for example, has cut the value of the Shenzhen-listed stock to 20.04 yuan and the Hong Kong-listed stock to 16.38 Hong Kong dollars, both 36% lower from their last prices on April 16. That translates to roughly a $7 billion loss in combined market capitalization.

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