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Is Huawei a Paper Tiger?

No large Chinese company is more scrutinized, criticized, ostracized and demonized than Huawei, the Shenzhen-based manufacturer of telecommunications equipment. With revenues of $28 billion in 2010, and 110,000 employees, Huawei is the second-largest telecom equipment company in the world, along with being the largest and most prominent private technology company in China. It is also said to enjoy significant behind-the-curtain support from senior figures in the Chinese government and military.

Not much is known about the secretive company. But for all its size and prominence in the telecommunications industry, Huawei’s corporate finances and balance sheet may be a good deal weaker than commonly assumed. The problem comes from Huawei’s unbalanced balance sheet, and an over-reliance on loans from Chinese state-owned banks, rather than payments from customers, to finance its business. In 2011, instead of too much help from the Chinese government, Huawei seems to have suffered from a lack of it.

The bigger Huawei has grown, the more criticism it has attracted. Competitors outside China have loudly claimed the company was a front for the Chinese military, and that it owes its size in large part to an efficient process of stealing others’ technology and then selling its cut-price knock-off equipment within China and to telecom monopolies in the world’s poorer, most despotic countries.

Huawei has had a particularly hard time of it in the US, where it was sued in 2003 by Cisco for patent infringement. More recently, its plans to buy several US tech companies were blocked by the US government or obstruction by US politicians. Some of the same politicians also blocked Huawei’s sale of some larger telecom equipment in the US by asserting, without producing any real evidence,  Huawei equipment was used by the Chinese military for eavesdropping.

In part to counter all the criticism and alter its reputation as a technological lightweight, Huawei has been spending heavily in recent years to build large R&D centers around the world, hiring lots of PhDs, both Chinese and Western. The company is filing patents by the truckload, a total of over 50,000 at last count. In 2010, the company is said to have invested over $2 billion in R&D. According to the company, profits in 2010 were Rmb24 billion (US$3.7 billion) up from RMB18.27 billion in 2009.

But, the question still remains: is Huawei a solid high-tech company that is misunderstood and unfairly attacked by jealous competitors or attention-seeking politicians? Or, is it more of a bloated, backward and barely profitable machine-maker kept in business through hidden subsidies and support from various arms of the Chinese government?

I have no way to accurately judge, nor any particular interest in the company. I meet with Huawei people occasionally. Huawei is, after all, the largest and most prominent company in Shenzhen, where I now live. As a private company, Huawei releases limited financial information.

My sense is that Huawei’s main problem, at least at the moment, isn’t technical competence, but poor cash flow. This has been brought on by fast-declining profit margins, slow market growth, erratic payments from customers in less-advanced countries where Huawei derives a significant percentage of its sales. To top it off, once compliant Chinese banks have turned stingy in extending loans. Add it up, and Huawei may currently be in much less robust financial condition than previously. A paper tiger? Probabaly not. But, it does look like a very large company with a similarly large imbalance in its financial structure.

To sell its products, Huawei must usually be the cheapest supplier. But, its costs are rising fast and some of its largest markets of late, like equipment for 3G and other high-bandwidth mobile phone systems, are no longer growing quickly. Other product areas are basically stagnant, especially for traditional fixed-line telecom switches.

Though the company has made no public announcement about its financial condition, my conversations with Huawei people suggest the company had a relatively poor year in 2011, and has run into some serious cash-flow challenges. One example: Huawei’s private equity arm, which until recently was trumpeted by Huawei as a key source of future profits and access to new leading-edge technologies, has all but shriveled up and died. Funding has been basically cut off. The cash is needed apparently to keep other parts of the business above water.

In the past, Huawei could sustain its cash flow by tapping China’s state-owned banks for loans. This year, the flow of loans seems to have been curtailed. One reason:  the Chinese government has clamped down hard on all bank lending to stem rising inflation. That’s impacted most heavy borrowers in China, including, it seems, Huawei.

Chinese banks have cut back lending to Huawei, so Huawei apparently has cut back elsewhere in its business. If so, it suggests Huawei’s own cash reserves are scarce, particularly for a company its size. This is caused not only by low margins, but also because Huawei, as a private company, cannot raise money from the capital markets. Its only cushion is taking loans from Chinese banks. These loans, in turn, are dialed up or dialed down not based purely on Huawei’s creditworthiness, but also the overall credit stance of the Chinese government.

The simplest solution, a Huawei IPO, seems as a remote a possibility today as it ever was. The company does not seem ready to endure that level of public disclosure — of its murky financials, ownership, profit margins, management structure, reliance on orders and loans from Chinese government-backed entities.

Over the years, most of Huawei’s erstwhile competitors – including Northern Telecom, Alcatel, Fujitsu, Siemens, AT&T – have either gone out of business, or been dramatically slimmed down. Only Sweden’s Ericsson has sales larger than Huawei.

In the absence of reasonable profit margins and reliable cash flow from customer purchases, Huawei has used a ready flow of Chinese bank loans to finance its operations and investment. But, those low margins also make it a challenge to repay the ever larger bank debts. Ultimately, positive cash flow needs to come from customers, not bank loans.

Whatever the situation with Huawei’s books at the moment, I’m rather sure we will not be reading financial headlines anytime soon about a cash crisis at Huawei. It is a large business,  and well-connected politically. It is also reportedly a large supplier of equipment to the Chinese military.

The large banks in China are state-owned and are routinely used to advance economic, political and social goals.  These banks may have cut back on funding to Huawei this year, but if the company needs money to stave off more serious – and public — financial problems, it’s all but certain the flow of bank cash will be increased. If need be, Huawei could be put on heavy state loan intravenous support.

As Huawei has grown larger, the reliance on bank lending becomes ever more of a risk. It is, above all, a very stilted, unbalanced way for the company to manage its capital needs. A diet of too much debt and too little equity often leads to corporate malnourishment.

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Companies That Can IPO & Companies That Should: The Return to IPO Activity in China

Ming Dynasty lacquer in China First Capital blog post

After a hiatus of nearly a year, IPO activity is set to resume in China. The first IPO should close this week on the Shenzhen Stock Market. This is excellent news, not only because it signals China’s renewed confidence about its economic future. But, the resumption of IPO activity will also help improve capital allocation in China, by helping to direct more investment to private companies with strong growth prospects.

With little IPO activity elsewhere, China is likely to be the most active IPO market in the world this year. How many Chinese companies will IPO in 2009 is anyone’s guess. Exact numbers are impossible to come by. But, several hundred Chinese companies likely are in the process of receiving final approval from the China Securities Regulatory Commission. That number will certainly grow if the first IPOs out of the gate do well.

Don’t expect, however, a flood of IPOs in 2009. The pace of new IPOs is likely to be cautious. The overall goal of China’s securities regulators remains the same: to put market stability ahead of capital efficiency. In other words, China’s regulators will allow a limited supply of companies to IPO this year, and would most likely suspend again all IPO activity if the overall stock market has a serious correction.

China’s stock markets are up by 60% so far in 2009. While that mainly reflects well-founded confidence that China’s economy has weathered the worst of the global economic downturn, and will continue to prosper this year and beyond, a correction is by no means unthinkable. There are concerns that IPOs will drain liquidity from companies already listed in Shanghai and Shenzhen.

Efficient capital allocation is not a particular strongpoint of China’s stock markets. In China, the companies that IPO are often those that can, rather than those that should. The majority of China’s quoted companies, including the large caps,  are not fully-private companies. They are State-Owned Enterprises (SOEs), of one flavor or another. These companies have long enjoyed some significant advantages over purely private-sector companies, including most importantly preferential access to loans from state-owned banks, and an easier path to IPO.

SOEs are usually shielded from the full rigors of the market, by regulations that limit competition and an implicit guarantee by the state to provide additional capital or loans if the company runs into trouble. So, an IPO for a Chinese SOE is often more for pride and prestige, than for capital-raising. An IPO has a relatively high cost of capital for an SOE. The cheapest and easiest form of capital raising for an SOE is to get loans or subsidies direct from the government.

Now, compare the situation for private companies, particularly Chinese SMEs. These are the companies that should go public, because they have the most to gain, generally have a better record of using capital wisely, and have management whose interests are better aligned with those of outside shareholders. However, it’s still much harder for private companies to get approval for an IPO than SOEs. Partly it’s a problem of scale. Private companies in China are still genuine SMEs, which means their revenues rarely exceed $100 million. The IPO approval process is skewed in favor of larger enterprises.

Another problem: private companies in China often find it difficult, if not impossible, to obtain bank loans to finance expansion. Usually, banks will only lend against receivables, and only with very high collateral and personal guarantees.

The result is that most good Chinese SMEs are starved of growth capital, even as less deserving SOEs are awash in it. More than anything, it’s this inefficient capital allocation that sets China’s capital markets apart from those of Europe, the US and developed Asia.

Equity finance – either from private equity sources or IPO — is the obvious way to break the logjam, and direct capital to where it can earn the highest return. But, for many SMEs, equity is either unknown or unavailable. I’m more concerned, professionally, with the companies for whom equity finance is an unknown. Equity finance, both from public listings and from pre-IPO private equity rounds, is going to become the primary source of growth capital in the future. Explaining the merits of using equity, rather than debt and retained earnings, to finance growth is one of the parts of my work I most enjoy, like leading to the well someone weak with thirst. Raising capital for good SME bosses is a real honor and privilege.

Most strong SMEs share the goal of having an IPO. So, the resumption of IPOs in China is a positive development for these companies. Shenzhen’s new small-cap stock exchange, the Growth Enterprise Market, should further improve things, once it finally opens, most likely later this year. The purpose of this market is to allow smaller companies to list. The majority will likely be private SME.

I’ll be watching the pace, quality and performance of IPOs on Growth Enterprise Market even more carefully than the IPOs on the main Shanghai and Shenzhen stock markets. My hope is that it establishes itself as an efficient market for raising capital, and that the companies on it perform well. This is one part of a two-part strategy for improving capital allocation in China. The other is continued increase in private equity investment in China’s SME.

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