Good morning,
This Thursday and Friday I will be a presenter and panelist at the University of Chicago Antitrust and Competition Conference, which this year is focused on Digital Platforms and Concentration. An overview and schedule for the conference is here, and the conference will be live-streamed here. Accordingly, as noted on the Posting Schedule, there will be no Daily Update on Thursday. Thank you for your understanding.
As for yesterday’s article, Zillow, Aggregation, and Integration, I am going to follow-up on it tomorrow along with Netflix’s earnings.
On to the update:
The ZTE Ban
From Reuters:
The U.S. Department of Commerce has banned American companies from selling components to Chinese telecom equipment maker ZTE Corp for seven years after breaking an agreement reached after it was caught illegally shipping goods to Iran, U.S. officials said on Monday. The U.S. action, first reported by Reuters, could be devastating to ZTE since American companies are estimated to provide 25 percent to 30 percent of the components used in ZTE’s equipment, which includes smartphones and gear to build telecommunications networks.
This decision is, at least on the surface, distinct from the ongoing and escalating trade dispute between the United States and China. To quickly zoom out, obviously the United States government cannot tell a Chinese company what to do. However, the U.S. government can tell American companies what to do, and that includes determining what technology can be exported, and to whom.
To that end, countries like Iran and North Korea have long been subject to U.S. sanctions, which means that it is illegal for U.S. companies in many sectors, particularly technology-related ones, to export products to those countries (including digital products like licensed software). And, by extension, U.S. companies cannot knowingly export embargoed products to companies that then sell those products to countries covered by those sanctions.
ZTE, however, has been well-known to have been violating those sanctions for years; for example, see this 2012 report from Reuters:
A Chinese telecommunications equipment company has sold Iran’s largest telecom firm a powerful surveillance system capable of monitoring landline, mobile and internet communications, interviews and contract documents show…The ZTE-TCI documents also disclose a backdoor way Iran apparently obtains U.S. technology despite a longtime American ban on non-humanitarian sales to Iran — by purchasing them through a Chinese company.
ZTE’s 907-page “Packing List,” dated July 24, 2011, includes hardware and software products from some of America’s best-known tech companies, including Microsoft Corp, Hewlett-Packard Co, Oracle Corp, Cisco Systems Inc, Dell Inc, Juniper Networks Inc and Symantec Corp.
This and other violations, including evidence of a systematic effort by ZTE to circumvent U.S. sanctions, culminated in export controls being levied against ZTE two years ago, under the Obama administration. However, the ban was never put in place after ZTE was given a number of reprieves, and the company finally settled with the U.S. government a year ago; from the New York Times:
As part of a settlement for breaking sanctions and selling electronics to Iran and North Korea, ZTE agreed to plead guilty and pay $1.19 billion in fines, the United States Department of Commerce said in an announcement. The penalty is the largest criminal fine in a United States sanctions case…
“ZTE acknowledges the mistakes it made, takes responsibility for them and remains committed to positive change in the company,” said Zhao Xianming, chairman and chief executive of ZTE.
The settlement had multiple pieces: there was a criminal penalty of $529 million, a civil penalty of $661 million, and a seven-year ban on U.S. company’s selling to ZTE; however, $300 million of the civil penalty and the seven-year ban were suspended as long as ZTE committed no more violations of the Export Administration Act, complete and submit six audit reports regarding ZTE’s compliance, and abide by a cooperation provision specifically requiring ZTE to “make truthful disclosures of any requested factual information”.
To that end, the U.S. government requested information about thirty-nine employees ZTE claimed had been disciplined for actively working to circumvent U.S. sanctions, including in a July 2017 letter sent after the settlement; it turned out that ZTE had disciplined none of them and had paid their full bonuses (as an aside, bonuses are a standard part of a salary in China, for even the lowest level employees — in other words, they are frequently not an expression of a job particularly well-done but simply another paycheck; that noted, I don’t know the context of the ZTE bonuses). This led to yesterday’s order from Richard Majauskas, Acting Assistant Secretary of Commerce for Export Enforcement:
In issuing the March 13, 2018 notice letter to ZTE, and in considering ZTE’s response, I have taken into account the course of ZTE’s dealings with the U.S. Government during BIS’s multi-year investigation, which demonstrate a pattern of deception, false statements, and repeated violations…ZTE’s July 20, 2017 letter is brimming with false statements in violation of§ 764.2(g) of the Regulations, and is the latest in a pattern of the company making untruthful statements to the U.S. Government and only admitting to its culpability when compelled by circumstances to do so. That pattern can be seen in the November 30, 2016 letter, which falsely documented steps the company said it was taking and had taken, as well as in the 96 admitted evasion violations described in the PCL, which detailed the company’s efforts to destroy evidence of its continued export control violations.
As Majauskas notes, ZTE admitted to the mistruths but said they were obviously unintentional:
ZTE acknowledged that it had submitted false statements, but argued that it would have been irrational for ZTE to knowingly or intentionally mislead the U.S. Government in light of the seriousness of the suspended sanctions. The heart of its argument is the question, posed by the company in rhetorical
fashion, asking “Why would ZTE risk paying another $300 million suspended fine and placement on the denied parties list, which would effectively destroy the Company, to avoid sending out employee letters of reprimand and deducting portions of employee bonuses?”
The answer seems pretty straightforward: ZTE presumed they would get away with it, just as they had previously. Surely the U.S. wouldn’t take such drastic action, not only angering the Chinese government but also hurting U.S. suppliers. But the U.S. has done exactly that.
Tech’s Trade War Risk
This is where, despite my long-winded explainer, it is difficult to separate this action from that trade dispute. Last Friday President Trump threatened more tariffs on an additional $100 billion of Chinese goods in response to China’s in-kind retaliation to Trump’s initial tariff on $50 billion in goods; the problem is that China only exports $130 billion in goods total. To retaliate in full means putting a tariff on everything, or hiking up the current tariffs even more.
Everything includes a lot of U.S. tech products that were spared in the first round, chief among these Apple. Indeed, as I noted a year ago, it’s theoretically possible (although unlikely) that Apple could get hit by tariffs from both side. The key detail comes from this New York Times report:
The customs operation is also in a so-called bonded zone, an area that China essentially considers foreign soil, subject to different import and export rules. This setup allows Apple to sell iPhones more easily to Chinese consumers…
A bonded zone functions much like a diplomatic territory, in that the government regards it as foreign soil. The zone eliminates the need for global brands to pay duties or taxes on imported components. And it makes it unnecessary to physically export the goods. In those zones, products can be imported and exported virtually at customs, without crossing a single border. After that, they can move swiftly around the country, or out to the rest of the world.
As I wrote at the time:
From the U.S. perspective, iPhones are “Made in China”; however, from the China perspective, iPhones are made in a foreign country. The net result is that in a trade ware iPhones could face tariffs on both sides (above and beyond the product’s symbolic significance for both countries).
Again, I highly doubt this double-tariff would happen, but I’m not sure that iPhones will be spared completely, either. Consider that $130 billion I referenced above: given that that number is calculated from the U.S. perspective, I don’t think it includes iPhones. From China’s perspective, though, Apple products are another American import, worth $46 billion; adding them in is certainly is one way to match Trump’s additional $100 billion.
Apple still may be spared: not only are its products particularly popular amongst the more politically important Tier 1 cities, their manufacture employs millions of Chinese — there is a reason Apple gets special custom zones! At the same time, this action against ZTE surely raises the risks of retaliation against tech companies generally and Apple specifically: ZTE’s punishment may have been legitimate outside of the context of a trade war, but that context is only theoretical; in reality there is a trade war and the U.S. government just kneecapped one of China’s tech champions.
The other major impact of both the trade war and this action against ZTE will be the further bifurcation of Chinese and Western technology; already there is a major separation at the services layer: Facebook/WeChat, Google/Baidu, Amazon/Alibaba, etc. No, they aren’t perfect comparisons (particularly Amazon and Alibaba), but they are symbolic of how the Great Firewall has resulted in two Internets.
What seems likely to happen in the long run is a separation at the hardware layer as well; China is already investing heavily in chips, and this action will certainly spur the country to focus on the sort of relatively low-volume high-precision components that other countries like the U.S., Taiwan, and Japan specialize in (to date it has always made more sense for Chinese companies to focus on higher-volume lower-precision components). To catch up will certainly take time, but if this action harms ZTE as much as it seems it will I suspect the commitment will be even more significant than it already is.
China’s Delayed Approval and Apple’s Pain
That noted, China has found another lever to hurt tech — Apple included. From the Wall Street Journal:
China is slowing reviews of multibillion-dollar takeover deals being pursued by Qualcomm Inc. and Bain Capital, people familiar with the matter say, as U.S.-China trade tensions escalate. The delay could end up quashing Qualcomm’s planned $44 billion purchase of Dutch semiconductor company NXP Semiconductors — a deal widely seen as critical to Qualcomm’s future—according to a person familiar with the matter.
China is the only country that hasn’t yet signed off on the Qualcomm deal and on Toshiba Corp.’s planned $19 billion sale of its chip unit to a consortium led by U.S. private-equity firm Bain Capital.
First off, Qualcomm is certainly paying the karma piper for President Trump squashing Broadcom’s attempted acquisition; not only is the company hurt by losing ZTE as a customer, now its own acquisition may be in danger.
As for Toshiba, I wrote about the deal last September:
It was reported that Apple fronted $7 billion to get the deal done, up from a proposed $3 billion; $1 billion is for equity, and $6 billion is debt.
This goes back to the recent run of sky-high memory prices I mentioned last week; Toshiba is the second-largest NAND-memory maker in the world (after Samsung), and it is critical to Apple that NAND capacity go up. If the company raises prices it surely wants to keep the increase; in fact, though, many of these price changes are going to memory makers instead.
To that end the company is apparently willing to put in $7 billion — 7x Google’s payment to HTC — to bend that price curve in the opposite direction. It is both a far more boring and also a far more important use of capital than Google’s acquihire, and, in its own way, an illustration of how far Google would have to go to even have a fraction of Apple’s hardware business.
On the flipside, Google, for obvious reasons, is the least at risk from this trade war; ZTE will have to stop using Google’s services (Google’s can’t sign a Mobile Application Distribution Agreement with the company now), but the company already took its China hit years ago. Apple has yet to truly feel the pain, but as the hold-up to this Toshiba deal suggests, the pain may have finally begun.
The Daily Update is intended for a single recipient, but occasional forwarding is totally fine! If you would like to order multiple subscriptions for your team with a group discount (minimum 5), please contact me directly.
Thanks for being a supporter, and have a great day!