Cisco's Chinese Nemesis
Huawei Technologies, a seven-person startup in 1988, expects to export $1 billion in telecom equipment this year. Founder Ren Zhengfei’s secrecy and charges of intellectual property theft linger.
Peter Randall’s first impulse was to choose Cisco Systems Inc. to supply the new phone system for Chestnut Hill Academy. “I love that company,” says Randall, technology director at the $17,000-a-year boys school, whose wide lawns and 19th-century buildings adjoin the Philadelphia Cricket Club.
Then reality set in. Randall’s budget was less than $200,000. Cisco’s price, which he declines to disclose, was going to be way be- yond that. “Every $30,000 you save means you can hire another teacher,” says Randall, who’d used Cisco gear at Internet service provider NetReach Inc.
In August, Randall decided on a switching system made by Huawei Technologies Co., thereby delivering a victory to China’s largest networking equipment maker and its March joint venture with Cisco rival 3Com Corp. “Some competitors tried to disparage the Huawei gear because it was foreign, but we’ve had excellent serv- ice from 3Com,” Randall says. “On a performance-for-dollar basis, it really was an easy decision.”
Randall’s decision marks the latest chapter in Huawei’s evolution. Founded in 1988 by a former Chinese army officer who’d failed in an early foray into the electronics industry, Huawei began as a seven- person startup making analog parts for old-fashioned telephone switchboards. Today, it has 22,000 employees, sells equipment in 40 countries and is pushing into the U.S. via its partnership with 3Com.
In China, Huawei’s share of the $1.4 billion market for switches and routers—the devices that direct traffic on communications networks—rose to 11 percent in the second quarter of 2003 from 7 percent in all of 2001. Cisco’s share fell to 61 percent from 64 percent, according to Framingham, Massachusetts–based research firm IDC. Huawei’s international sales surged 70 percent to $558 million during the same period. This year, Huawei expects to export $1 billion of equipment, spokesman Fu Jun says.
“Huawei will be a threat to Cisco,” says Andrew Chetham, a Hong Kong–based analyst at research firm Gartner Inc. “Huawei is obsessed with Cisco. In fact, Huawei wants to be Cisco.”
The Cisco-Huawei rivalry illustrates how Chinese companies are putting Western competitors on edge. The two sides are beginning to spar over everything from prices to intellectual property, to standards for corporate openness.
China’s exports soared to $265.8 billion this year through August, a third more than a year earlier. Exports of telecommunications gear, laptop computers and TV sets were up even more. In the first half of 2003, the value of China’s technology-related international sales jumped 55 percent to $44 billion—more than 20 percent of all exports. In 2002, China overtook the U.S. as the favorite destination for foreign direct investment, attracting a record $52.7 billion.
“It’s the same dynamic the world faced in the last century with the rise of America,” says Kenneth Courtis, Tokyo-based vice chairman in Asia of Goldman Sachs Group Inc., who’s toured Huawei headquarters in Shenzhen, a booming city of 7 million that’s an hour by train or ferry from Hong Kong. “When you have an aggressive, no-holds-barred competitor that’s on the make, it upsets the status quo,” he says. “And in this business, Cisco is the status quo.”
Cisco isn’t shying away from Huawei’s challenge. In January, it sued in U.S. federal court in Marshall, Texas, alleging that its Chinese rival had copied software, had stolen the language used to write pro- grams, had plagiarized instruction manuals and had infringed patents to produce cheaper, knockoff routers. CEO John Chambers says it’s the first time the world’s largest maker of net- working equipment has taken a competitor to court. “Creativity and innovation are at the heart of this industry, but creativity is not copying and innovation is not misappropriation of intellectual property,” Chambers told Bloomberg News in February. Chambers declined to comment for this story.
Huawei denied Cisco’s claims. On March 17, it countersued in the same court, claiming that Cisco’s lawsuit amounts to unfair competition. On Oct. 1, the rivals called a truce, agreeing to suspend their litigation for six months so that independent experts they didn’t name can review changes Huawei has made to some switches and routers. Spokesmen for Cisco and Huawei say they hope the negotiations and review will resolve the lawsuit. Details were confidential.
Theft of intellectual property is only one charge critics have leveled against Huawei. In November 2001, Gary Mil- hollin, director of the Wisconsin Project on Nuclear Arms Control, which tracks weapons of mass destruction, told a U.S. Senate subcommittee on international security that Huawei had helped Saddam Hussein improve Iraq’s air defenses by supplying fibeoptic equipment. The sale violated a United Nations embargo, he said.
Milhollin repeated the allegations in September 2002 be- fore the House Armed Services Committee and in a September 2003 interview with Bloomberg News. “Our intelligence guys told me about it,” he said, declining to identify them. “Huawei was definitely a culprit.”
Zhou Jin, 38, a Huawei senior vice president, denies the charges. “It’s absolutely not true,” Zhou says. “We are a telecommunications equipment provider. This gossip has been around for many years.”
Some of the gossip springs from the secrecy that surrounds Huawei founder and CEO Ren Zhengfei. Ren, 58, who rose from his rural upbringing as the son of impoverished schoolteachers to become an officer in China’s People’s Liberation Army, is a mystery even on Huawei’s campus. When he travels in an elevator full of employees, no one recognizes him, says Richard Lee, manager of Huawei’s advertising department. There are no pictures of him at headquarters, and his name doesn’t appear in Huawei’s annual reports. Reporters have never interviewed Ren, Lee says, and he declined to talk to Bloomberg News. “I loved to remain unknown and never sought personal fame or gain,” Ren wrote in a 2001 article in Huawei’s corporate newspaper, describing his more than 10 years in the PLA, China’s 2.5-million-strong army. “I still possess that fine quality today.”
Huawei is almost as chary with its financial details. Spokesmen say it’s a private company owned by its employees and that no worker—including Ren—has a stake of more than 5 per- cent. Zhou says 80 percent of employees own shares, which aren’t publicly traded. He says Huawei plans an initial public offering at some point.
Huawei’s last complete annual report was for 2001. In September, Huawei supplied Bloomberg with a consolidated income statement, balance sheet and statement of cash
flows for 2002. The report shows that revenue fell 7 percent to $2.12 billion from the prior year and that net income tumbled 61 percent to $108 million. In comparison, Cisco’s sales for the fiscal year that ended in July 2003 fell less than 1 percent to $18.9 billion, while profit surged 89 percent to $3.58 billion.
Spokesman Fu says his company is back on the growth track, with $1.57 billion of orders in the first half of 2003— a third more than a year earlier. Huawei doesn’t release semi- annual or quarterly profit reports. “Huawei’s going to have a good year,” says Gartner’s Chetham, who reviewed the figures.
‘If he were American, he would be perceived to be heroic,’ 3Com’s CEO says of Huawei founder Ren.
3Com CEO Bruce Claflin, among the few Westerners who’ve met Ren, is outraged by Milhollin’s comments that link Huawei to Hussein. Claflin and Ren signed their joint venture pact on March 18, the eve of the U.S. invasion of Iraq. Claflin’s son is a pilot in the U.S. Marine Corps, and the CEO says he’d never do business with a company that helped the former Iraqi dictator. Nor is Claflin bothered that Ren made a career as an officer in the PLA. “Ren’s personal story is like a classic American success story,” Claflin says. “If he were American, he would be perceived to be heroic.”
Claflin, 52, is betting that teaming with Huawei will pro- vide the focus that’s eluded 3Com in its myriad incarnations. 3Com started as a networking consultant in the late 1970s; in the ’80s, it added switches, routers and adapter cards that connect PCs to networks; and in the ’90s, it became a modem maker and owner of PalmPilot handheld computers via its $7.3 billion purchase of U.S. Robotics Corp. In 2000, 3Com sold shares in Palm Inc. to the public and spun off the rest to shareholders. 3Com’s share price reached a high of $21.89 in March 2000 before falling 84 percent to a low of $3.45 on Sept. 17, 2001. The stock was trading at $6.77 on Oct. 10— still 69 percent below its peak.
Claflin says 3Com hopes to gain better access to the $1.4-billion-a-year Chinese market for switches and routers. 3Com also wants to take advantage of Huawei’s 10,000 engineers, who earn salaries of about a fifth of the $120,000-plus that their U.S. counterparts make, Claflin says. “Over time, we could pose a real competi- tive threat to a company that up to now has had no competitive threat,” he says, referring to Cisco.
Some investors are betting on a more immediate benefit to 3Com. They say linking with Huawei may help restore 3Com to profitability. Marlborough,
Massachusetts–based 3Com has turned in 14 straight quarterly losses totaling $1.83 billion. And its sales have fallen for 18 quarters in a row, dropping to a 10-year low of $161.9 million in the first quarter of fiscal 2004, which ended in August.
3Com’s share of the $109-billion-a-year global market for communications equipment dropped to 0.9 percent in the first half of 2003 from 1.2 percent in 2001, according to Phoenix- based Synergy Research Group Inc. Cisco’s share climbed to 15.7 percent from 10.3 percent. Huawei’s rose to 2.8 percent from 2 percent.
“The reason I own 3Com is the Huawei joint venture,” says Jim Grefenstette, Pittsburgh-based manager of the Federated Growth Strategies Fund, which has $700 million in as- sets, including 1.2 million 3Com shares. Grefenstette expects the 3Com-Huawei partnership to win sales among U.S. companies looking for a cheaper alternative to Cisco.
In the month after the companies unveiled their venture, 3Com shares climbed 27 percent to $5.36 compared with a 1 percent rise in the Dow Jones Industrial Average. During the same period, Cisco stock fell 2 percent to $13.95. On the day the companies suspended their lawsuits, 3Com rose 9 percent to $6.45. Cisco gained 3 percent to reach $20.20.
Gordon Astles, Cisco’s president of Asia-Pacific operations, says he doesn’t see the Huawei-3Com joint venture as a major threat, even in China, where Cisco gets 5 percent of its global sales. “Cisco is holding its own in China,” Astles says.
‘In China, it’s making Cisco nervous,’ one analyst says of Huawei’s rapid growth and rising market share.
Analysts and investors agree that Cisco is in no peril of losing its top spot in networking equipment. “3Com and Huawei aren’t going to displace Cisco, but their alliance could certainly make them a thorn in Cisco’s side,” says Shawn Campbell, who was an analyst at Northern Trust Co. until July, when he started his own fund firm, Campbell Asset Management.
One group that Huawei will have to win to jab at Cisco is made up of big corporations. Cisco controls 81 percent of the global router market and 68 percent of the market for switches, according to Redwood City, California–based Dell’Oro Group Inc. “That’s going to be a tough stranglehold to break,” says Don Burdick, senior vice president of information systems at Costco Wholesale Corp., the largest U.S. warehouse club chain, with annual sales of $38 billion. Burdick says Issaquah, Washington–based Costco spends as much as $5 million a year on Cisco gear and services. He’s never heard of Huawei.
Vijay Bhagavath, an analyst at Cambridge, Massachusetts–based Forrester Research Inc., says he conducted a confidential survey in which he asked top companies whether they’d trade higher-priced Cisco equipment for Huawei gear. The answer: Most would stay with Cisco because it’s reliable and has
technicians to service the equipment. “The cost of downtime could be a hundred or a thousand times the cost of the equipment,” Bhagavath says. A $5,000 Cisco 3760 switch costs about $2,000 more than the Huawei equivalent, he says.
Huawei’s technology spans the telecommunications spectrum, making it more diverse than Cisco’s. Huawei makes base stations and antennas for mobile phone services; videoconferencing equipment; and hardware and software for fixed- line, cellular and optical networks. Gartner ranks Huawei No. 2, behind France’s Alcatel SA, in digital subscriber line ports for handling high-speed Internet connections.
Huawei is also developing a mobile phone technology known as TD-SCDMA, the standard that China is adopting to deliver so-called third-generation, or 3G, services that give users Internet access fast enough to make video calls. A potential market of 1.3 billion Chinese citizens is waiting.
“Six years ago, nobody knew about Huawei,” says Chris- toph Caselitz, president of Siemens Mobile, a unit of Germany’s Siemens AG, which is teaming up with Huawei in a $100 million joint venture to develop TD-SCDMA service in China. Now, “Huawei is a highly renowned player in China,” he says. “People say, ‘Well, they are just copying and copying.’ Even if they were, the speed of execution would be impressive.”
Caselitz says Huawei is developing original technology too. He says Huawei’s mobile phone networks and its best- qualified engineers are two areas in which it excels.
Even before joining with 3Com, Huawei was making progress in competing against Cisco in China. The reason is that Huawei isn’t only serving companies like China Mobile Communications Corp. anymore; it’s also winning customers among the foreign corporations that once dealt almost exclusively with Cisco. “Huawei has a huge sales force in China and excellent after-sales service,” says Craig Watts, a director at Beijing-based research firm Norson Telecom Consulting. “In China, it’s making Cisco nervous.”
Ren’s company-newspaper account of Huawei’s founding points up a parallel with Cisco’s roots: The company began like a Silicon Valley startup in a one-room house in Shen- zhen. In 1992, Huawei graduated to digital switches and then developed its own semiconductor and moved into data and mobile technology.
Gu Wenjie, an analyst at MFC Insight, a Beijing-based telecom research firm, says Huawei owed much to Ren’s PLA connections. Spokesman Fu says Huawei works with civilian companies, not the military. In either case, Gu says, Huawei’s growth followed the path that Japanese companies had taken in the 1960s and South Koreans adopted in the ’70s: “Steal technology at first, reverse engineer the technology so as to learn ‘how to’ and then sink significant amounts of money into original R&D to keep up with the competition.” By reverse engineering, Huawei broke down a piece of equipment to understand how it worked and then built gear based on that model.
Today, Gu says, “Huawei is perceived by its competitors as a credible, high-tech, global player rather than sim- ply a bottom-feeding company that reverse engineers technology and steals market share through cutthroat pricing.”
The change at Huawei is apparent in the scale and style of its headquarters. With its lush lawns, palm-fringed driveways and 21-story glass-and-steel research center, Huawei exudes Silicon Valley cool. “That research center is like something out of the next millennium,” says Goldman Sachs’s Courtis.
Young techies in casual Western dress stroll or cycle to their cubicles from company-provided condos in an enclave called the 100 Herb Garden. The residential area is complete with a swimming pool and volleyball and tennis courts. In the reception building, a showroom displays the newest products—among them, one of the Quidway brand routers at the center of Cisco’s complaint.
Huawei has hired Western consultants to improve management. Ren brought in International Business Machines Corp. to teach Huawei how to keep track of the thousands of parts that flow into its seven factories in China. And Huawei hired U.S. human resources consulting firm Towers Perrin to work out a stock option plan. “They have really invested serious time, resources and money to try to improve their systems,” says Andrew Arnold, Hong Kong director of U.S. human resources firm Hay Group. Hay helped Huawei develop ways to increase the pay of employees who performed better and took on more responsibility than their peers. In China, under the communist system, performance- based pay was unknown. “Chinese companies often have problems in this area,” Arnold says.
MFC Insight casts doubt on the value of such efforts. Gu says that even with Huawei’s Silicon Valley appearance, Ren runs it on military lines. “It remains questionable whether the money paid to outside consultants will change Huawei into a company with methodical management systems,” he says. “Ren plays the most important role and makes the final decisions.” Such top-down leadership threatens Huawei’s development, says Gu, who spent six months researching Huawei and who’s visited its headquarters.
Such fears haven’t deterred Western companies from beating a path to Huawei’s door in search of partnerships. Last year, Huawei and Microsoft Corp. the world’s biggest maker of computer software, agreed to open a joint lab to develop telecommunications software at Huawei’s Shenzhen headquarters.
In September, Huawei teamed up with Infineon Technologies AG, Europe’s second-biggest semiconductor maker, to work on 3G phones. Infineon, based in Munich, will pro- vide chip sets and software; Huawei will provide network technology and software.
A week later, Vodafone Group Plc, the world’s biggest provider of mobile phone services, completed a four-month test of Huawei equipment for 3G networks. Managing Director Jonathan Kriegel says Vodafone may buy Huawei base stations and antennas.
Today, Huawei has 32 foreign offices. Among them are research centers in Dallas, Stockholm, Moscow and Bangalore, India. The Bangalore site is based at the Leela Palace hotel, where Huawei has 80,000 square feet on three floors of the commercial section of the hotel called Leela Galleria. By comparison, Santa Clara, California–based National Semiconductor Corp. has space on just one floor.
Huawei sells its equipment in 40 countries, mostly emerging markets such as Brazil, Egypt, Mexico, Russia and Thailand. Prices that can be half of Cisco’s help it win business. In Thailand, Huawei installed a mobile phone network for Advanced Info Service Pcl, the country’s largest telecommunication services company, which is owned by the family of Prime Minister Thaksin Shinawatra.
“They’re willing to customize things for us,” says Kriengsak Wanitnatee, AIS’s assistant vice president techni- cal. Last year, Huawei’s sales topped $100 million in both Thailand and Russia, Fu says.
In Germany, Huawei helped build networks for cell phone operators PfalzKom AG and Stadtnetz Bammerg GmbH. In France, it set up the network for No. 2 Internet service provider Free SA. In Spain, it sold optical systems to Madrid-based phone company Grupalia SA. “It’s a tremen- dous company,” says Goldman’s Courtis.
Zhou won’t say when Huawei will go public. “We do plan to be listed somewhere sometime, but we have no timetable,” he says. “We’re still in the planning process.”
Liu Yang, managing director in Hong Kong of London- based Atlantis Investment Management, says she won’t be lin- ing up to buy shares. “This company has some controversial issues,” Liu says. “There are so many other excellent compa- nies around.” She prefers China Shipping Development Co., the country’s biggest oil shipper; Brilliance China Automotive Holdings Ltd., China’s biggest minivan maker; and pharma- ceutical stocks like China Pharmaceutical Group Ltd.
To succeed in the stock market or the marketplace, Huawei will have to erase doubts like Liu’s. Cisco won’t be the only one watching its progress.„