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Telecom's Future: Made in China?

The quadrennial ITU Telecom World show in Geneva may be a worldwide confab, but one global trend has a lot of people worried. Occupying prime real estate smack in the middle of the exhibition hall are booths from two of the fastest-growing communications-equipment makers on the planet, Huawei Technologies and ZTE Corp., both based in mainland China. While telecom's old guard -- Lucent Technologies (LU), Nortel Networks (NT), Alcatel (ALA), Ericsson (ERICY), Siemens (SI), Motorola (MOT), and others -- fight to stave off flat or declining sales, these ambitious Chinese upstarts are logging revenue gains up to 30% annually.

Perhaps the most startling and visible manifestation of this divergence of fortunes was also on the exhibition floor of Telecom World 2003, sponsored by the U.N.'s International Telecommunications Union. Most of the old giants don't even have booths. After spending an estimated $40 million on its lavish display at the Telecom 1999 show, Alcatel, for instance, opted instead to sit this one out. "It's the changing of the guard," says one analyst.

DOMESTIC FUEL. That's likely too strong a conclusion. Huawei and ZTE had 2002 revenues of $2.7 billion and $2 billion, respectively, while U.S. and European players fell in the range of $12 billion to $30 billion. But the trend lines are irrefutable. Blessed with a surging domestic market and solid engineers who are paid as little as one-tenth as much as their Western counterparts, Chinese equipment giants are gaining sales at the expense of rivals with lower-price products that perform most, if not all, of the same functions.

This year's Telecom World show may not signal the changing of the guard, but it certainly signifies the emergence on the global stage of potent new players (see BW Special Report, 10/20/03, "The Wireless Challenge").

The strong Chinese market is a big source of their success. In 2001, it became the world's largest mobile market -- now with an estimated 240 million subscribers. And last year China overtook the U.S. for the first time in fixed-line connections. Service revenues still lag well behind those in the U.S. and Japan, but supplying the exploding domestic market with traditional phone circuit switches, mobile equipment, Internet routers, and even handsets has been extremely lucrative for China's hometown heroes.

MOVIN' ON UP. Now they're increasingly turning their sights to the export market. Their ace, of course, is dramatically lower prices, thanks to the cut-rate cost of Chinese engineering and manufacturing. Some 75% of ZTE's sales come from China today, but by 2008, senior vice-president Shi Lirong told the ITU Telecom World 2003 show daily newsletter, ZTE aims to have annual sales of $10 billion, half from outside China.

Huawei has achieved a similar level of exports, with 20% of last year's revenues coming from outside China. In 2003, says Executive Vice-President Wen Wei Xu, overall sales are expected to climb 30%, to $3.5 billion, while the dollar value of exports should surge 100%, to more than 30% of revenues.

Both companies now get the bulk of their non-Chinese sales in the developing world, where Western suppliers aren't as ingrained and where buyers on limited budgets are more likely to be attracted to inexpensive Chinese equipment. But Huawei and ZTE are convinced they will succeed eventually at moving up the food chain.

"There's a growing acceptance of our products in developed markets, and we're building up higher levels of trust," Huawei's Xu told the ITU show newsletter. Agrees ZTE's Lirong: "In four to five years, ZTE will start making the vendor short list for international operators."

REBUILDING CREDIBILITY. The old guard is still talking a tough line, however. "Huawei has a lot of growing up to do," says Niel Ransom, chief technology officer for Paris-based Alcatel. "It remains to be seen whether it can compete in more complex stuff." Indeed, the Chinese company rocketed to fame earlier this year when it was sued by networking giant Cisco Systems (CSCO) for allegedly copying Cisco technology in knock-off routers and switches.

The suit has since been suspended, though not dropped, by mutual agreement of both parties, as they try to reach a less adversarial resolution. In the meantime, Huawei has entered into highly visible partnerships with networking pioneer 3Com (COMS) and Germany's Siemens, which have helped restore its credibility and assuage customer concerns over the legality of Huawei's technology.

Still, the feeling remains that Chinese vendors are mostly reusing Western engineering, not inventing much of their own. As with earlier technology migrations from the U.S. to the Far East in the consumer-electronics and PC businesses, Asian makers are helping commoditize once esoteric and high-margin products -- saving money for buyers but pulling down prices and profits for established suppliers.

IRREVERSIBLE TREND. Incumbents ignore the threat at their peril. "We never underestimate competitors," says Steve Pusey, the president for Europe, Middle East, and Africa at Canadian communications equipment giant Nortel Networks.

To become serious global contenders, though, Huawei and ZTE will indeed have to move beyond low-cost versions of Western gear. And both say that's just where they're headed. Huawei spends 14% of revenues on research and development, while ZTE's figure is about 10%. But that's a much smaller amount that the established crowd. Throughout the telecom downturn, Nortel, for one, kept R&D spending high on cutting-edge technologies such as Internet-based switches, even as it trimmed back on mature projects. "Technology innovation is what will keep us ahead," says Nortel's Pusey.

That's fine for high-end gear. But the relentless tendency to commoditization -- even for complex stuff like telecom and Internet equipment -- is irreversible. Recognizing this, outfits like Lucent, Alcatel, and Ericsson have all started pushing more into the business of high-margin services and consulting, rather than relying solely on selling boxes.

COMPLETE TRANSFORMATION? Alcatel has made it clear that it's willing to install and service equipment from any vendor if customers insist. Could that someday include Huawei boxes? Alcatel CTO Ransom concedes it might, if the Huawei product doesn't compete with a strategically important Alcatel offering.

Here's a scenario sure to ruffle some feathers: While the old telecom giants continuing moving up into services and other "knowledge-based" businesses, companies like Huawei and ZTE could grab a growing share of the global communications-equipment market. It seems far-fetched, but perhaps by the time of the next Telecom show in 2006 or 2007, Lucent will once again have a booth -- highlighting its transformation into the world's largest distributor and integrator of Hauwei boxes. Anybody want to place a bet? By Andy Reinhardt at ITU Telecom World 2003. Follow BusinessWeek's exclusive telecom coverage, only on BusinessWeek Online

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