It's unfortunate, but the reality of politics in America these days is that it's sometimes hard to tell the difference between political posturing for the benefit of the constituents who watch TV and legitimate issues of national importance. Take the recent report from the U.S. House Intelligence Committee that recommends U.S. companies and government agencies avoid doing business with Chinese firms Huawei and ZTE - is this a legitimate concern for U.S. security, or just an unnecessary pre-election kerfuffle? Perhaps even more critical to investors, however, is the question of whether Congress intends to put any real force behind this recommendation, and whether there will be consequences for American hardware vendors such as Cisco (Nasdaq:CSCO) and Juniper (Nasdaq:JNPR).

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Prudent Caution or Paranoia?
A series of cyber attacks that were traced back to China led the U.S. Congress to launch a more thorough investigation and examination of potential technological vulnerabilities in the United States. Part of the output of that process has been this report from the U.S. House Intelligence Committee that largely singles out Huawei and ZTE as posing potential threats to U.S. security. Curiously, the report did not detail any particular examples or allegations of misconduct. Rather, it seems that a lot of the concern was motivated or fueled by the companies' reticence to provide all of the information that the investigators wanted, including information about the companies' ties to the Chinese government. The companies argued that the requests were excessive and intrusive. At the bottom line, though, the recommendations seemed pretty clear. The Committee would like to see U.S. companies avoid doing business with Huawei or ZTE, would like to see the U.S. government not buy or use equipment from these companies, and would recommend refusing permission to potential acquisitions of U.S. companies by these companies.

Minimal Real Impact Today ...
One significant detail that the report really didn't address is that neither of these companies currently do substantial business in the U.S.. Although Huawei and ZTE have become quite successful within China and fairly successful in some foreign markets, they have relatively small share with U.S. carriers. What's more, ZTE doesn't seem especially ambitious about its U.S. hardware business (smartphones may be another story), so this is more of a potential issue for Huawei.

... But a Response Is Almost Certain
It would be almost unthinkable that the Chinese government would not respond to this report. The risk, then, is pretty straightforward - if ZTE and Huawei are unwelcome in the U.S., China could likewise block U.S. companies such as Cisco, Juniper, F5 (Nasdaq:FFIV) and Acme Packet (Nasdaq:APKT) from the Chinese market. Given the sizable differentials between the Chinese companies' current shares in the U.S. market and the growth prospects offered by China for American companies, this wouldn't be a net-positive trade-off for the American side. What's more, Ericsson (Nasdaq:ERIC), Alcatel-Lucent (NYSE:ALU) and Nokia Siemens would be more than happy to fill the gaps created if China becomes less hospitable to American equipment vendors.

SEE: Investing In China

It's also worth asking if this is even a winnable battle. I certainly understand the theoretical risk. There are stories of U.S. intelligence forces cooperating and collaborating with U.S. and allied country companies to essentially create backdoors in products sold to "politically questionable" nations; these can then then be exploited by U.S. intelligence to cause problems for the target countries (the alleged Soviet pipeline sabotage in 1982, for instance). So it's not unthinkable that the Chinese government could force these companies to give them access to their products, which could then become potentially problematic.

But here's the problem - a large percentage of equipment sold by U.S. tech companies passes through China at some point. Apple (Nasdaq:AAPL) and Dell (Nasdaq:DELL) have almost all of their equipment manufactured in China, and both Cisco and Juniper also make use of outsourced manufacturing too. If China was really so focused on causing trouble, wouldn't it be possible for the Chinese government to likewise enlist the cooperation of assemblers and component manufacturers to create security loopholes?

The Bottom Line
Much as I'm a pro-free trade advocate, I can't really quibble with the idea that a national government probably shouldn't buy its hardware or software from rival nations that aren't exactly friendly (or at least not allies). Going a step further, however, and suggesting that U.S. companies avoid equipment from ZTE and Huawei is something of a different story. I'm not suggesting that the U.S. government should put profits above security, but starting a trade war isn't helpful either. What's more, so long as the U.S. is basically comfortable with having Chinese companies supply components and assembly services for U.S. tech companies, it seems harder to me to support the case against Huawei and ZTE. After all, locking a window is all well and good, but rather pointless if you leave the backdoor ajar.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.



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Tickers in this Article: CSCO, JNPR, AAPL, DELL

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