Huawei Technologies and ZTE Corp. are the leading telecom equipment manufacturers. Both companies rose rapidly during the past decade for their aggressive sales in overseas markets. In 2009, they benefited from the surge in operator spending on 3G at home (see my separate posting). Huawei, for example, reported revenue from domestic sales passed $10 billion in 2009 or about 47% of total revenue, while share of overseas sales fell to 53% from 75% in 2008.

The same appeared to be true for ZTE. The company is yet to disclose annual results, but a company executive predicts sales grew 25% (estimated at $7.7 billion) thanks in part to CDMA equipment orders by China Telecom, while profit may jump 43-56% (about $350-380 million). Mid-year data show a 117% increase in domestic sales while oversea revenue edged up .7%.

The stunning rise, especially for Huawei, has drawn a lot of attention lately. The Shenzhen-based company was little affected by the global economic calamity as revenue rose 17.5% to $21.5 billion on contract sales of over $30 billion, while most of its rivals, i.e., Ericsson, Nokia Siemens Networks, Alcatel-Lucent and Motorola fared poorly. By 3Q, Huawei’s overall rating in telecom equipment market had risen to 20%, surpassing NSN and Al-Lu in about a year, while shares for Ericsson, the No. 1 vendor, fell to 32% from 35%. To a certain extent, Huawei’s gains came at the loss of yesterday’s power players, especially in emerging markets. Some predict Huawei will overtake Ericsson in three years to become the largest equipment company in the world. It’s quite a feat for a company of a little over 20 years old.

However, as base numbers swell, growth is slowing amid fierce competition, tough market conditions and issues at home. While 17% growth in revenue is remarkable, it is a sharp drop from 43% a year ago. Is this the beginning of a trend for Huawei as it enters “midlife” after revenue made 42% CAGR six years in a roll? Mr. Ren Zhengfei, founder and the brain behind Huawei’s success, remains confident. He insists his company will score 20% growth in contract sales this year or to $36 billion.

Focus Shift

This year will be a good test for Huawei and ZTE. As all Chinese operators will retreat from capex for 3G, equipment orders are expected to decline sharply. This will force Huawei and ZTE to turn to overseas again to sustain growth. They cannot afford slips in overseas since it accounts for such a large percentage of revenue (excluding 2009, it was 75% for Huawei and 60% for ZTE).

Huawei will likely push its foray in the US this year. In the past, Huawei tried numerous times to crack the US market with little success, including the failed attempt to acquire 3Com. Revenue is estimated at $100 million compared to $3 billion in Europe. In a way, the US has become a “holy grail” for Huawei – a symbol of a true world-class company. The situation began to improve in 2009 as Huawei sold 3G equipment to Cox Communications and WiMAX to Clearwire. Recently, Huawei earned praise from Verizon in its test of new-gen GPON equipment. Huawei plans to add 600 employees in its US operations to a total 1,500. ZTE has made less impact in the US; most of its sales are handsets for T-Mobile and Sprint.

Two strategies have helped Huawei and ZTE in overseas sales. First, when the two companies were less known, they used low pricing to beat the incumbent. The strategy turned out very effective especially in emerging markets where customers were concerned about their ability to pay for equipment and vendor’s commitment. In the past, Huawei and ZTE even went a step farther by offering vendor financing or guarantee for commercial loans for customers. This has helped their entry in new markets in Africa, the Mideast and South Asia.

After they’ve built reputation as a serious competitor, they begin to win customers with technology not just pricing. They are not techno “copycats” but devotee to new standards and products. They allocate 10% of revenue and large personnel to R&D. This has paid off in mature markets where customers are less sensitive about pricing. Recently Huawei lost an LTE expansion contract from TeliaSonera in most Norway after a win in Oslo, but Huawei insists it will not engage in price wars, a turn from its past position.

The Flip Side

Huawei is a closely held company which offers some latitude in business dealings such as sales tactics, pricing and profit, but it is not without perils. For example, even though the company has won many projects overseas, it admits some did not make money or may have lost money due to deep cut in price. Another negative effect is low profit margins. During 2003-07, for example, gross PM fell sharply from 19% to 7% and net PM from 14% to below 5%. And 2009 may have fared no better, if we assume profit at $1.2-1.3 billion, then profit margin is about 5.5%.

Huawei also carries a heavy debt load. As the 2007 figures show, the most recent data available, Huawei had a debt-to-asset ratio of 67% and accounts receivable soared over 50% from 24% in 2004.

In recent months, Huawei and ZTE have encountered more resistance in the form of unfair competition and antidumping charges. India, for example, accused Huawei and ZTE of selling SDH equipment below market price and imposed high tariffs. Why does it matter? India is a critical source of revenue for Huawei, accounting for 8% in 2008 ($1.7 billion). ZTE has 2,300 employees in India with annual revenue between $800 million and $1 billion.

A long-term issue is leadership. Mr. Ren is in his 60s and his departure will inevitably affect Huawei’s future. As the first step, the company has created an “Executive Management Team” to take on day-to-day operations. However, it is not clear how effective by relying on a team rather than CEO for critical decision-making, and whether there is such a person in the company to succeed Ren.

ZTE also faces obstacles. The company reportedly suffered a high inventory level (62%) in 2007 and ran a negative cash flow in 2008 for about 4.5 billion yuan ($660 million). In addition, while the company is doing well overseas, 48% of its international revenue came from only five countries: Ethiopia, India, Indonesia, Nigeria and Uzbekistan. This makes ZTE somewhat vulnerable given political, social and economic conditions in these countries.

Finally, ZTE is a smaller player than Huawei. Although it gives the company an edge in things like agility and product development, it makes it less competitive in broad terms such as marketing, finance and support. For customers in emerging market, a small company is often associated with instability and low commitment.

Analyses are solely the work of the authors and have not been edited or endorsed by GLG.

Source:Gerson Lehrman Group