NATIONAL CHAMPION
How ZTE is taking China’s economic ambitions to the developing world.
By Tom Leander

A powerful earthquake struck Algeria near its capital on May 21, 2003, collapsing buildings and killing more than 2,200 people. The temblor threw the government into chaos. Homeless Algerians stoned the president’s motorcade when it swung through the most damaged area, as accusations of government corruption and shoddy building standards flew in Algiers.

Patrick Wei, head of the financial supervision department for the Chinese telecommunications equipment manufacturer ZTE, had stepped off the plane at Algiers-Houari Boumedienne Airport only the day before. It was his first big assignment overseas. He had been sent as an emissary of CFO Wei Zaisheng to win a contract to build a mobile phone network under the CDMA standard – Algeria’s first. The quake had rattled him in his hotel, the government was embattled, and as far as the deal was concerned, all bets were off.

“Don’t take no for an answer,” said CFO Wei when Patrick phoned him in far-off Shenzhen, where ZTE is based. Anyway, there was no point in coming back. The SARS epidemic was shutting down businesses all over South China.

So Patrick stayed – for eight months. He moved from his damaged hotel and stayed in a barracks with a Chinese medical unit that had been flown in to aid in the disaster. He ate couscous and drank Algerian tea. By year-end he had landed an innovative US$47m loan package that combined financing from Société Générale and the Industrial and Commercial Bank of China with a guarantee from Sinosure, China’s export credit insurer, for a six-and-a-half year tenure. It was a long slog to win. Patrick describes the experience as ‘more of a zig zag to victory’. For one, he had to convince the Algerian telecoms ministry that ZTE possessed the standards and equipment to build the network and operate it under a managed contract at low cost.

But in the end, Patrick and his team turned out to be strong persuaders. ZTE’s bid undersold its two US rivals by 18% and 21%, respectively, delivering the project for US$32m, something that the US companies, with their higher employee and R&D costs, would never have been able to realize.

In the past three years, ZTE has repeated the act again and again. It has struck ever larger deals from Ghana to Lesotho, most recently winning a US$200m equipment contract for wired and mobile access networks for Ethiopia Telecommunications on April 29. Principally, these have been victories based on price. How did ZTE manage to sell its products and services so much more cheaply than its rivals?

In several compelling ways, but the most controversial is via its own project financing methods. ZTE declines to discuss the financial arrangements of deals since Algerie Telecom. But in meetings with multinational telecom operators and private equity investors, ZTE makes no secret of one key advantage: because of its national champion status, ZTE can obtain low-cost money that it can then lend to its own customers.

In their presentations, CFO Wei and his team draw a picture of a PRC government, flush with US$1 trn in foreign exchange reserves. That money is funneled through lending channels, via preferential loans from the China Ex-Im Bank, through the China Development Bank or commercial banks such as Bank of China or Industrial and Commercial Bank of China. Loans for African contracts are being encouraged via preferential loans from government banks, a de facto subsidy. Although ZTE wouldn’t discuss the lending rate, analysts say it is well below the 6.39% benchmark one-year lending rate in China (upped from 6.12% on April 28). The US prime rate – or the rate that US banks give to their favored customers – is currently 8.25%.

ZTE is so confident of the way it handles these deals that it prefers to manage the loans internally. “They feel they can take on the supplier risk themselves,” rather than going to an international bank for structured finance, says a banker who worked on the Algerian deal.

Of course, all major telecoms equipment providers engage in customer financing. But Russell Southwood, CEO of Balancing Act, a consulting firm and online publisher specializing in internet and telecoms in Africa, sees a difference in ZTE’s methods. “Cisco,” he says, “might go a similar route, but it would use a combination of donor funding, soft loans, and international bank financing. You could actually see when and how a decision was made to put money into a project.”

With ZTE, however, there is no transparency in customer lending. “Not only are they offering preferential loans, but it’s impossible to tell what add-ons become part of the package. They’re likely to say ‘if you want something like EBDO (a 3G mobile voice technology), we’ll wrap it into the price,’” says Southwood. “They undoubtedly are the cheapest in the market.”

Perhaps, but is ZTE competing fairly?

Activist finance

It’s natural that Shenzhen, a city flung up in a mere 20 years, would be home to two of China’s aggressive telecom companies. From the highway, concrete housing developments and cavernous exhibition centers alternate between big public parks and amusement centers. A near-size replica of the Eiffel Tower can be glimpsed from the highway.

In this town, China’s two major telecom equipment companies have emerged with distinctly different styles. Privately owned Huawei, long rumored to have connections to China’s military, has its own exit from the highway. Its Silicon Valley-style campus is palatial. Ironically, it is the environs of publicly owned ZTE that more strongly resemble what one would expect from a state-owned company. The ZTE skyscraper has broad corridors that have the official feel of a government ministry. In a showcase lobby, LCD screens flash depictions of African equipment deals – government ministers and political leaders from Sudan, Eritrea, Niger, Algeria, Libya, and Zambia celebrating agreements on projects.

Unlike Huawei, which has made inroads into the more lucrative developed markets of North America and Europe, ZTE’s sales executives have become wizards at selling telecommunications in the developing markets of Africa and Asia. African sales, for one, increased 90% in 2005.

In this gung-ho environment, the finance department acts both as engine and safety valve, providing internal project financing and monitoring risks and costs.

CFO Wei is passionate about the model. “Communications has now joined food, clothing, housing, and transportation as a basic human right,” he writes in a position paper dubbed “New Trends, New Approaches,” that he hands out to guests. In the paper, he throws the gauntlet down to rivals Alcatel-Lucent, Nokia, Ericsson, and Motorola. “Ideally,” he writes, “the technological monopoly formed by traditional equipment vendors must be broken.”

CFO Wei urges finance departments to become leaders in their own right. “To be successful,” he says, “a CFO should be active in three areas – product sales, capital markets, and money markets (banks).” He says that his job is to leverage the advantages of being a Chinese homegrown company in a business dominated by established global players. This means “competing on cost, not on price.” Yes – but lower costs allow ZTE to deliver lower prices.

Not surprisingly, not everyone sees ZTE’s tactics in such positive terms. In the words of one industry analyst who works for a Western consulting firm, China is “trashing the commodity side of the telecoms business.” That’s one way of putting it. Critics of ZTE and rival Huawei say they sell cheaply to troubled governments like the regimes in Algiers or the Sudan in deals that effectively amount to foreign aid – and with the full support of the Chinese government.

Others say this may be true, but so what? There’s hardly a global business that isn’t influenced by geopolitical concerns. “To say that they’re trashing the business is unfair,” says Duncan Clark, chairman of BDA Consulting, a telecoms research firm based in Beijing. “ZTE has made enormous inroads due to more than cheaper financing. It has shown flexibility in poorer countries in a way that the larger Western providers have not.”

Competing like champions

There is indeed far more to ZTE’s strategy than cheap capital. The telecoms industry is fiercely competitive and ZTE has had to find creative ways to compete.

According to Clark, one reason that ZTE has been gaining on the competition can be seen in what rivals are willing to do in the production of handsets. If a multinational or local operator partners with Nokia, customers in that particular market are locked into the Finnish giant’s standardized products and approach. “But in the developing markets it’s often a case of ‘I don’t care. Just give me a phone,’” says Clark. “ZTE is willing to forgo its branding, go the white label approach and customize to what operators and customers want.” On the equipment side, Clark says, ZTE is very strong on providing value-added solutions to features developed on networks. These might include customized ring, ring-back tone services, and mobile-phone billing systems. “We can meet diversified local requirements,” says CFO Wei, “at a lower cost than Western vendors.”

Southwood agrees that ZTE is willing to be flexible in a way that major Western vendors cannot. “The Nokias and Ericssons of the world,” he says, “have to package services at scale. Below a certain threshold they can’t be flexible and make money.” He adds that ZTE may be able to do so, “but whether from subsidy, as rivals would claim, or because they can operate more cheaply, is hard to read.”

ZTE can indeed keep costs low. When CFO Wei Zaisheng, Patrick Wei, and Chen Hu, finance controller, travel to would-be customers, they bring along a list of telling comparisons. China boasts 2m annual engineering graduates, while France has 300,000 and Germany can claim only 100,000. Average annual salaries of engineers in China amount to 150,000 renminbi per year (US$19,000), as opposed to roughly US$110,000 in Germany and France. Likewise, Chinese laborers work 50 hours on average, whereas French and German laborers pack up and head home after 38. And so on. These verities are used to demonstrate that ZTE’s engineers and service providers work at higher value and lower cost than rivals. That means ZTE can price managed contracts to run telecom networks for national operators more cheaply.

There’s nothing unfair about this strategy – it’s a competitive practice open to all. And competitors are jumping on it. Almost all of the global peers of ZTE have set up manufacturing bases and R&D centers in China in pursuit of lower costs, mimicking the Chinese model. According to BDA China, the cost of hiring engineers in China for Alcatel-Lucent’s Alcatel Shanghai Bell subsidiary is 27% of that in Europe.

“The battle is being brought back to China,” says Michael Meng, analyst for Citigroup in Hong Kong. “Now Western companies have access to China’s 2m engineering graduates per year, too.”

And it’s easy to forget, because of their success, how small in comparison to big Western companies ZTE and Huawei actually are. Alcatel-Lucent posted US$25 bn in sales in 2005. Huawei reported US$6 bn in sales, while ZTE tallied US$2.1 bn. Their revenues were just 24% and 9% respectively of the combined sales of Alcatel-Lucent in 2005.

Is it necessary?

ZTE may be smaller, but size isn’t everything in this dynamic industry (see box, “Young and Ambitious”). But does ZTE need preferential loans from government banks to gain business when it has proven so adept at winning in other ways? There are risks beyond the political risk of lending to customers in unstable countries. The Chinese government may eventually change its policy, making the loans more expensive. And the loans themselves bear what economists call moral hazard – the threat that the lenders will lose discipline because of cheap money and lend indiscriminately.

Moreover, ZTE may soon succeed spectacularly on its home turf. Its investments in R&D have been huge, equivalent to 10% of revenues per annum. Analysts say that once TD-SCDMA and other 3G technologies become operational – at least by the Olympics in 2008 – ZTE will be the biggest telecom equipment beneficiary
in China. “ZTE is at the forefront of R&D of the still unproven
TD-SCDMA technology,” writes Fang Meiqin, principal analyst at BDA in Beijing. Fang expects that ZTE will eventually leap ahead to take 30% of China’s 3G market once the new standard takes hold, compared to the 8% share of the 2G market it now retains.

But with its push into international markets and its massive R&D effort at home, the company is like a man straddling the gunwales of two boats, struggling to maintain equilibrium. Net profits declined 40% for 2006 compared with the prior year. CFO Wei pegs the lower-than-expected profits to the investment in R&D in 3G products.

But the company has also been trying to put a lid on sales, general, and administrative (SG&A) expenditures. In 2005 alone, ZTE increased the number of employees in marketing, sales, and customer service for its overseas business by 70%.

This expansion has socked operating margins. At 8%, ZTE is close to Alcatel Lucent’s 10.6% but well behind Huawei at 14%. Ericsson and Cisco, at 21.8% and 29.9% respectively, are in a class by themselves, largely because of lucrative contracts in the developed world.

Wei and his team are trying to stanch the cost leakage. A cost-control program led by the finance team was initiated in mid-2006. It has so far managed to reduce SG&A to 19% of sales, 200 basis points lower than expected, according to Citigroup’s Meng. A newly approved share incentive plan was initiated to align managers’ pay with cost control. The plan stipulates that the company must maintain more than a 10% return on net assets in 2007, Meng says. “The major objective is to establish a long-term incentive mechanism,” says CFO Wei, “by linking financial performance to corporate strategies.”

And there are reputational hazards in ZTE’s African business that the company might wish to avoid in the future. The company donated 144m Kenyan shillings (US$2.1m) in 2005 to Telkom Kenya, and was awarded a contract to install 26,000 switching lines in Nairobi and Mombasa. ZTE’s country representative in Kenya, Zhang Jianke, told local newspapers that ZTE “did not expect anything in return” for the donation. A gift like this might not slip past a review under the US Foreign Corrupt Practices Act (FCPA), which casts a harsh eye on gift giving. But China has no act similar to the FCPA.

“To the extent that public procurement contracts are not allowing for bonafide competition,” says Harry Broadman, chief Africa advisor to the World Bank, “they are certainly not in the long-term interests of economic development.” Broadman is the author of a study of China and India in Africa called “Africa’s Silk Road,” published by the World Bank. He adds that overall the presence of fierce competitors like ZTE and Huawei is good for African markets, because it presents alternatives for poorer nations that previously had no choice.

And that’s what the activity is to CFO Wei, who dubbed communications a ‘right’ to the world’s poor in his own writing. He knows that the Western telecom equipment companies will soon be leveraging lower cost R&D in China to compete mightily on price in the developing world. What harm in seizing the advantage now?