Profits Warning And US Probe Hit ZTE Shares
China-based telecommunications equipment manufacturer ZTE has warned that it may see a sharp 80% drop in net profit for H112 on the back of smaller and deferred supply contracts, higher foreign exchange losses and increased competition. At the same time, European and US regulators have stepped up their separate probes into the company's opaque business practices while reports that a new US Federal Bureau of Investigation (FBI) will scrutinise the company's deals with Iran have sent the embattled vendor's share price spiralling downwards. BMI assesses the impact these latest blows will have on the company's standing on the international stage.
ZTE's share price fell by 32.4% over the week ended July 11 2012 and fell even further over the week that followed as news broke regarding the latest FBI investigation. The ZTE share on the US equities market has fallen by at least 117% over the last 12 months (see chart) as concerns grow that its ascendancy on the global equipment supply stage have been achieved through unorthodox and, possibly, illegal means. If the FBI can prove that ZTE illegally supplied US-made computer products to Iran, as is alleged, the company could find itself blacklisted by many of the US' trading partners worldwide, as well as the finance markets. With Chinese economic and technology growth poised to slump and with its fallback position in non-US aligned emerging markets brining greater pressure on its otherwise successful low-margin strategy, BMI believes that ZTE could quickly find itself in deep trouble.
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ZTE estimates that H112 net profit could be down by 60-80% y-o-y to between CNY154 and CNY308mn. The company notes that it has been particularly badly exposed to adverse foreign exchange rates and the relatively strong Yuan, which have hit sales in Europe and emerging markets in Latin America, Asia and Africa. The company has proved extremely adept at winning business in emerging markets, where it has been able to drastically undercut the prices charged by long-term players Alcatel-Lucent, Ericsson and Nokia Siemens Networks (NSN), among others. This practice was sustainable only as long as the company continued securing new orders but, with its principal customers in the low-end market now satiated, the company has had to target more mature markets, where loyalty to the old-school suppliers remains strong despite an equally strong desire to obtain next-generation network (NGN) solutions as cheaply as possible.
The return to recessionary conditions in Europe and North America means that many operators have chosen to forego much-needed network upgrades until the financial markets stabilise. At the same time, anti-trust authorities in Europe and the US have been pressing the company to disclose details of its financing sources, as rumours persist that the company illegally benefits from subsidies provided by the Chinese state, either directly or through channels such as investment funds that own shares of ZTE or through Chinese banks, which allegedly offer preferential loans to the company.
It is alleged that, in 2010/11, ZTE's Iranian unit agreed to supply US-sourced computer equipment worth at least US$200mn to Iran's incumbent telecommunications operator, in contravention of US embargoes on sales of such products to Iran. As the transactions - like the issue of Chinese financing - fall outside US jurisdiction, the FBI's case will be difficult to prove. Equally, though, the allegations will be just as hard for ZTE to disprove unless it opens its books to international scrutiny, a move it has long opposed.
However, the investigations of the FBI and the US Department of Commerce could now force the company into the open or into a full-scale retreat. Even if they can find no tangible evidence of wrong-doing, the agencies could pressure the US' global trading partners into refusing to do any further business with ZTE, which has already been blacklisted from key supply tenders in Algeria and Australia, among other states, and this would damage the company's chances of recovering its competitive momentum in the medium term.
ZTE is also suffering from a slowdown in demand for its equipment from Chinese fixed and mobile operators, which now have sufficient capacity to see them through the next two to three years and have also been returning to foreign suppliers such as Ericsson and Alcatel-Lucent for more advanced IP networking technologies.
BMI believes that, while some emerging market economies will remain unconcerned about ZTE's reputation, the vendor may have to adhere more closely to accepted international business practices and set more realistic prices for its products. Therefore, even these frontier markets will quickly become tougher for ZTE to crack within the next few years.