Cisco: In Hot Pursuit of a Chinese Rival

The U.S. giant is suing Huawei for theft. And the upstart, with its new ally 3Com, faces a rough slog

It's the shimmering jewel of China's high-tech industry. With its mile-wide campus bordered with palms, Huawei Technologies in the city of Shenzhen is China's answer to Silicon Valley's Cisco Systems (CSCO ) Inc. Its 10,000-plus engineers represent the country's best and brightest -- and they work for salaries only 20% as high as their counterparts in California. What's more, its state-of-the-art factories, equipped with mammoth robotic parts-picking systems, fill orders for its networking gear with world-class efficiency.

Huawei appears positioned to become a power in the world's networking industry -- except for one very large problem. On Jan. 23, after an eight-month investigation, Cisco launched a sweeping lawsuit against Huawei, alleging a host of intellectual-property violations and pushing for an injunction to remove certain Huawei products from the market. Huawei responds that the injunction Cisco seeks is unwarranted, and that it has already addressed Cisco's concerns. Still, the suit has derailed Huawei's expansion into the U.S. market. And it may have led Huawei to seek an alliance to bolster its presence and credibility in networking. A month after the suit, Huawei announced a global joint venture with Cisco's longtime rival, 3Com Corp. (COMS )

The result is the odd couple of networking. It's the much feared newcomer under the cloud of possible scandal and the American has-been, battered for years by Cisco and looking for a muscular ally. On paper, the combination of Huawei and 3Com appears rich with promise. The 51-49 joint venture, with control potentially switching from Huawei to 3Com within two years, could ship products as early as this summer. It provides Huawei with 3Com's global distribution system, along with a strong base in the U.S. And it lets 3Com, which invested $160 million in the venture, fill gaps in its product line and exploit Huawei's low-cost operations. "It is a marriage of convenience," says one Western banker in Hong Kong.

Why would 3Com's CEO Bruce Claflin marry his company to an accused pirate? Claflin says he did so only after 3Com had carried out a detailed investigation of Huawei's source code. Terms of the venture include warranties by Huawei that its products do not infringe intellectual rights. Even if certain Huawei products turn out to have Cisco code, Claflin believes it was not done with management's blessing and has confidence in the company's future offerings.

Cisco begs to differ. Officials say Huawei's infringements are more pervasive. When Huawei and 3Com announced their venture, the reaction at Cisco was, at best, mixed. While Claflin says he had a cordial chat that day with Cisco Chairman John T. Chambers, Cisco Executive Vice-President Charles H. Giancarlo says: "I was so mad I couldn't speak for three days."

Now, China's networking star is back on its heels, and there is little relief in sight. Following Cisco's suit, the company says it's eager to address Cisco's concerns and establish a clean bill of health. But Cisco is keeping the pressure on. It has filed the suit in plaintiff-friendly East Texas, near Huawei's Dallas office. And it's not ruling out suing Huawei in other countries or suing the joint venture. Huawei must also refute charges from U.S. officials that it skirted U.N. sanctions by selling network gear to Saddam Hussein's regime. "It's absolutely untrue," says Huawei's Executive Vice-President Guo Ping. If all this weren't enough, Claflin faces surgery in May for removal of a benign brain tumor.

Then there's SARS. Huawei gets 80% of its sales in China, where telecom sales were expected to fall 12% this year, even before the epidemic, says researcher RHK Inc. Huawei's sales fell from $3.1 billion in 2001 to $2.7 billion last year. And now it's facing competition at home from upstarts such as Harbor Networks Hosting Co. and Uptech Ltd.

For Huawei, this is all part of a painful and risky transition. While CEO Ren Zhengfei has brought in top-shelf consultants such as IBM to help build the 15-year-old company, it has benefitted from cheap labor, strong government support, and a relaxed attitude about intellectual rights. That worked as it grew in the Chinese market. But the battle in global markets means hewing to tougher rules. "We want to be judged by the same standards as any world-class company," says Guo.

Even beyond legal concerns, Cisco has reason to keep Huawei on the run. Cisco, with $18.9 billion in 2002 sales, dominates the global market for network gear. Its gross margins are a mouthwatering 70%. That contributed to Cisco's 35% earnings growth, to $987 million, in the quarter ended in April, even while revenue fell 4.2%, to $4.6 billion. Although smaller, Huawei typically undersells Western rivals by 30% or more and is content with lower margins. Even now, weakened by SARS and the Cisco lawsuit, the company is feared. "Huawei is a threat to everyone," says Christine Heckart, vice-president for marketing at rival Juniper Networks (JNPR ) Inc. "They bid on everything that moves."

And they've been selling products that look and feel much like Cisco's. For years, even casual observers could see that Huawei's Quidway routers had Cisco-lookalike model numbers and technical specs. Now, Cisco claims that Huawei copied hundreds of pages of Cisco manuals. And Cisco says it found some of its own bugs in Huawei's software. "It's about as likely as two people sitting down to write Hamlet and coming up with exactly the same words," says Michael Howard, principal analyst at Infonetics, a market researcher. Huawei denies that it copied Cisco's products.

3Com's Claflin says he confronted Huawei executives with these issues. In the course of a technical review during the joint venture talks, the companies say they learned that one Huawei engineer admitted using software from a CD he had been given in 1999 that included Cisco code for a little-used networking standard. Last fall, Huawei and 3Com agreed to remove the potentially tainted code from their joint offerings. Claflin's team also urged Huawei to replace its Cisco-like commands, manuals, and packaging with 3Com's. Huawei officials say they agreed to.

In December, before suing, Cisco lined up support in China. Chief Counsel Mark Chandler says he notified the Chinese government of the pending suit and sounded out its reaction. Cisco's leverage: global trade. Having joined the World Trade Organization only in 2001, China is eager to shed its reputation as the world's leading haven for software piracy. As a result, the government appears to be letting Huawei fend for itself. Says an official at China's Ministry of Information Industry: "The government will not give any political help to Huawei."

It looks like a rough slog for the odd couple. True, Cisco sounds a conciliatory note. "Our goal has always been to simply have them stop copying our [intellectual property]," says Chandler. "When there's a verifiable mechanism in place to do that, the litigation ends." But now that Cisco has a fearsome rival on the run, any settlement is likely to be on Cisco's terms.

By Peter Burrows in San Mateo, Calif., with Bruce Einhorn in Hong Kong

— With assistance by Bruce Einhorn

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