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Huawei sanctions ‐ truth and consequences, Part 2

June 28 2019
by Eric Hanselman, John Abbott, Brian Partridge, Melanie Posey, William Fellows


Introduction


In Part 1 of this two-part exploration of the sanctions imposed on Huawei by the US government, we dove into the actions that Huawei's partners and others have taken. This second part will look at the repercussions and consequences of those actions, and at possible paths forward for the broader market. To recap, Huawei and many international subsidiaries have been added to the US Department of Commerce (DoC) Bureau of Industry and Security (BIS) Entity List. There is the chance that, like sanctions on ZTE or Mexico, the problems will all blow over, but there's a lot that hangs in the balance if they don't.

The 451 Take

The initial reaction from some organizations to the US administration's placement of Huawei on the BIS Entity List was swift and dramatic, ranging from promises to sever supply lines to changes in relationship status. As time has passed, some reactions have mellowed and others have clarified with nuances. Huawei and the Chinese government have each explored retaliatory measures, and the recent threat and withdrawal of tariffs on Mexico have emboldened those that might believe that the restrictions could be lifted before they have a significant effect. Behind this is the reality that this is the product of a different trade battle than the US has faced before. Having a challenger with technology, manufacturing scale and a sizable domestic market to consume it puts the US in a new and complex situation. Technology providers have their hands full in trying to make sense of an unpredictable course of events.

Déjà vu all over again?


There have been concerns about international technology battles in the past, and it may be tempting to assess the current situation along those lines, but the current tension between the US and China is different. In the 1980s, Japan was seen as tapping the technology prowess of the US. A headline in Fortune magazine in 1987 claimed to identify 'How Japan Picks America's Brains.' There were concerns that American intellectual property was being appropriated and that Japan was winning the battle for technological superiority. The idea of trade restrictions was floated, but the successful prosecution of a number of legal cases seemed to blunt their urgency. The fact that there was a strong dependence on the US market might also have helped.

The situation with China differs in a number of areas. There is concern that the Chinese legal system may not be able to offer sufficient protections for intellectual property rights. At the same time, the Chinese market, while nascent in comparison with western appetites for technology products and services, could dwarf their potential, giving Chinese companies fewer incentives to resolve international disputes. A strong central government has had advantages in technological innovation, as well. In telecommunications, the ability to mandate spectrum reallocation more rapidly than some western governments, for example, has opened opportunities for 5G infrastructure buildout sooner.

The consequences


If the BIS license expires and is not renewed, Huawei's partners will be legally prohibited from conducting the vast majority of their normal business relationships. That means different things to different organizations. For vendors to Huawei, it can mean a full cessation of product shipments. For those that have licensed technology to Huawei, there is a more complex calculation. Existing licenses where technology has already been transferred seem clear, but there is a looming question of support that we will explore in more detail below. It appears that Huawei will be able to continue to manufacture under existing licenses, but new designs will be restricted.

Huawei has extensive academic relationships. The company funds research and scholarships at a number of colleges and universities. This entails complex interactions with these institutions, since Huawei is involved in early-stage research as both a contributor and beneficiary. In the immediate aftermath of the BIS announcement, the Institute of Electrical and Electronics Engineers (IEEE), one of the primary technology standards bodies, advised technical committees and journal review boards that Huawei employees would no longer be allowed access to prepublication material. It reversed the ban a week later, after indicating that it received clarification from the DoC, but not after receiving considerable international concern about the intrusion of domestic political pressure in what was expected to be an open, international process.

Another complexity in the standards world, where the IEEE, 3GPP, ETSI and others operate, is the issue of intellectual property licensing. Huawei has a very large percentage of the declared standards-essential patents (SEP) – patents that are identified to standards bodies as being essential to the implementation of a standard – for a number of technologies. The declaration process comes with a commitment to grant licenses to these patents on reasonable commercial terms. By some measures, Huawei is the largest holder of 5G SEPs, with Nokia, ZTE, Qualcomm, Samsung, LG Electronics and others following closely behind. This means that Huawei already holds rights to many of the technologies that the US restrictions are trying to limit. Most of the vendors involved have cross-licensing agreements in place – one more interdependence in the market.

Initial technology market impacts


Uncertainty had already begun to have an effect on organizational strategies before the BIS sanctions were in place. The series of sanctions and tariffs has cut into margins and pushed prices higher. As an example, Cisco had initially absorbed tariffs as they were rolled out, but raised prices as they increased. Some vendors are shifting supply chains, while others may not be able to. Foxconn, an ODM supplier to Apple and many other technology vendors, has indicated that it would be willing to shift manufacturing locations to help customers adapt. It's not a change that is taken lightly, since even if a supplier can shift locations, the rest of the logistics in the supply chain have to be moved, as well. Apple is said to be unlikely to shift production, and one anchor is continuing Chinese market demand.

Prior to the most recent BIS actions in Q1 2019, the 451 Research Digital Pulse, Workloads and Key Projects study asked respondents about the extent to which the US government's trade and tariff policies are affecting organizations' IT strategies and planning. The aggregate result was 27% saying it had a 'significant' or 'moderate' effect. Outliers on impact included 'early tech adopters' (39%), organizations whose IT spending skews more toward 'growth/transformation' than 'maintenance/operations' (40%), 'very large organizations over 10,000 employees' (38%) and manufacturing (47%).

The long Arm of silicon


Huawei is an architectural licensee of Arm, which means it's invested heavily in extending basic Arm cores for its own purposes, most obviously in the Kirin phone processors and the recently launched Kunpeng 920 datacenter processor. If the situation is not resolved, it represents a massive blow for both companies, and there's no obvious alternative for Huawei to divert to, at least not without a costly and time-consuming engineering effort on a massive scale. It's possible that some SoC-level inclusions from the US could be engineered out, but only at considerable effort. Just before the news broke, Huawei announced that it would be building a 400-person chip R&D center in Cambridge, UK, just a 15-minute drive away from Arm headquarters, where it planned to design new network broadband chips and AI technologies.

Other Chinese customers developing Arm-based components, such as Phytium Technology, will also be hit. In 2018 SoftBank said that 95% of China's advanced chip designs were based on Arm, and that IP licensing fees to the country made up 20% of its revenue. SoftBank even sold off a majority stake in its China subsidiary to local investors for $775m and transferred IP rights to the subsidiary so that China could tailor the technology to its own needs. Chips designed and built there are still subject to US restrictions. Arm is not alone in setting up operations in China with local ownership. Intel has invested heavily in Chinese partnerships for three decades (more than $7.5bn) and has ongoing joint ventures with Chinese investors such as Jintide X Montage (a combination of CPU and FPGA). AMD also has a joint venture, developing the Hygon x86-compatible CPU.

Chinese companies have been experimenting with alternative chip architectures for some time, with many of them used in supercomputing. As well as the Arm-based Phytium chip, there is the ShenWei (Sunway) CPU, with an instruction set 'inspired' by the DEC Alpha chip, and the ZX family of x86-compatible processors from Zhaoxin, a joint venture between Taiwanese VIA Technologies and the Shanghai municipal government. All three of these are currently in the market. Arm's difficulties might be good for the RISC-V open source ISA and core movement, which is gaining momentum in China through groups such as the China Open Instruction Ecosystem Alliance (backed by Alibaba, Baidu, SMIC and multiple universities).

Other effects


Ramifications for the US semiconductor industry go well beyond Huawei, and are already affecting a broad range of established chip companies in multiple industry sectors, with most of them entwined in complex international supply chains. Qualcomm, Broadcom and Xilinx, for instance, are major suppliers to Huawei and to many other Chinese systems and technology houses. Also affected are the more than 70 startups globally that are in the middle of developing a new generation of accelerator chips for workloads such as AI and deep learning, which lose a large segment of their total addressable markets. The Semiconductor Industry Association has warned that the export restrictions 'undermine the ability of the US semiconductor industry to compete globally' and called for the government to work on a resolution that 'ensures the economic security of an industry that is the backbone of this country's technology leadership in key areas such as AI, quantum computing and next-generation telecommunications.' According to SIA figures, US chip sales hit $468.8bn in 2018, its highest ever total, up 13% from 2017. But the figures from recent months have seen a sharp decline.

Global markets have discounted a range of stocks of companies that are associated with Huawei and others that are anticipated to be caught in the periphery. Analog Devices stock was off more than 20% shortly after the BIS announcement, but has largely recovered. Micron's and Intel's stocks haven't been as fortunate.

Others could benefit from a ban. Samsung, Nokia and Ericsson could benefit by filling the void in the medium to long term. Nokia and Ericsson are the number-two and -three providers of mobile broadband infrastructure globally. Uncertainty around Huawei's ability to deliver 5G infrastructure or regulatory uncertainty around the ability to source products from Huawei could fill their respective pipelines. Samsung lacks the scale of Nokia and Ericsson, but has strong technology, is a leader in 5G deployments in South Korea and has committed to a massive investment to drive 5G market share globally. Alternative 5G suppliers, such as Altiostar, Affirmed Networks, Mavenir and Parallel Networks, could capitalize on opportunities and become more attractive acquisition targets.

Cloudy weather for Huawei


The impact on Huawei's $11bn Enterprise Business Unit is less clear, but the vast majority of this revenue comes from China, EMEA and outside of the US. Access to server, storage and associated technologies will impact enterprise portfolio refresh; however, the butterfly effect of the Entity List will be more significant, along with any further rollback from using Huawei in 5G (such as in the UK or Netherlands) and the knock-on effect on local service-provider and enterprise buying behavior as a result.

Of this $11bn, about $1bn is cloud revenue – again, done mostly inside China. This does not place Huawei among the top five IaaS players by revenue – AWS, Microsoft, IBM, Rackspace and Alibaba – according to 451 Research Market Monitor; however, its aspiration had been to make that list. Although it's a small number in and of itself, cloud has become the delivery mechanism not only for basic infrastructure services, but also, increasingly, as the underpinning for all kinds of additional services – from consumer phone services (Huawei Mobile cloud) to AI and security. Its reach extends beyond the Enterprise BU.

Outside of 5G, most non-US operators already use Huawei gear. Some, such as Deutsche Telekom, Telefonica and Orange Business Services, also deliver cloud services based upon Huawei hardware, software and services, and in some cases these are also operated by Huawei. However, we believe the revenue from these to be inconsequential for Huawei. What's more at risk are the cloud services Huawei has stood up to support its 450 million Consumer Business Group mobile phones (they also support its e-commerce operations [over 200 million users], 510 million IoT devices and internal IT systems with 800 apps). This revenue is not counted in the $1bn, and likely dwarfs it. Huawei has set up its own cloud services in regions where it does not have partners, and these are being used to support the local needs of Huawei's consumer, business and carrier customers. For example, roughly 90% of capacity in its Huawei Cloud in Russia is already allocated to local Huawei operations. Huawei has (or plans to offer) cloud services in Thailand, Hong Kong, Peru, Brazil, Chile, Mexico, Saudi Arabia and South Africa. All told, Huawei has cloud services available in 23 regions, with 40 availability zones.

Huawei reacts


There are a number of measures that Huawei has taken in response to the sanctions. It has filed a lawsuit challenging the constitutionality of Section 889 of the National Defense Authorization Act. The suit asks for the measure to be rescinded. Its patent portfolio has come to the fore in demands that it first made of Verizon in March to license its intellectual property. Negotiations are ongoing and likely to extend to other network operators, if successful.

Huawei has also launched a public-relations offensive, with founder Ren Zhengfei holding a panel discussion of the effects of the sanctions. He says that Huawei expects revenue to be $30bn lower than projected over the next two years, if the sanctions are enforced. He also believes that there are some options for alternative technologies that might soften the impact.

Huawei has explored its own smartphone operating system, called Plan B, but hasn't fully developed it. If it can no longer source semiconductors and software from the US, Huawei could find itself in a period of its own 'space race,' where it becomes a self-sufficient supplier, using its own intellectual property and unrestricted suppliers, which would push it to full vertical integration. Over time, restricted markets could once again open to Huawei, which could compete on technology and price.

China reacts


The Chinese government is taking actions to emphasize its concerns. The National Development and Reform Commission (NDRC) has held meetings with international technology companies that include Arm Holdings, Cisco Systems, Dell Technologies, Intel, Microsoft, Nokia, Qualcomm, Samsung and SK Hynix. The meetings are reported as conveying cautions about the impacts of acting too hastily on sanction-related issues. The NDRC has also warned that it would consider limitations on the export of rare earth minerals that are used in technology applications. Alongside this, China's commerce ministry has suggested that it would create an 'unreliable entity list' of companies involved in sanctions enforcement.

China has already launched initiatives to foster technological independence. The 'Made in China 2025' program was kicked off in 2015 under a previous administration, and targeted technology alongside medicine and manufacturing. In the Xi administration, the program hasn't been as visible, but still appears to have support.

Domestic challenges


Domestic resistance is being raised, as well, and it's taking a number of forms. On June 4, the acting chair of the Office of Management and Budget, an appointee of the current administration, requested a delay in the enforcement of the National Defense Authorization Act. He cited concerns about the ability to enforce sanctions and the impacts on rural telecommunications operators that have deployed Huawei equipment.

FedEx sued the Commerce Department on June 24, seeking relief from requirements to enforce sanctions as part of its shipping operations. In May, Huawei had complained that international shipments had been routed through FedEx's Memphis, Tennessee shipping hub. FedEx had indicated that this was a shipping error, but the lawsuit implies that it's being asked to be a more active participant in US efforts to constrain Huawei's operations.

Conclusions?


The push and pull of domestic tensions will be amplified as the August 19 expiration of the BIS general license looms. The administration floated ideas about discussions that could take place with China at the Group of 20 (G20) talks in Osaka on June 28-29. While there was posturing from both sides, it's likely that there will be limited movement – as with previous tensions, resolutions haven't materialized well in advance of looming deadlines. The US administration seems bound to win concessions from China, and it is unlikely to back down as easily as it did on Mexico sanctions. It seems reasonable to expect that there will be brinksmanship that will run right up to, if not through August. That means all effected organizations will have to plan for market disruption and hope that it doesn't come.