In a phone industry built on global division of labor, what does it mean that ZTE can't buy American chips and software?

If the ban takes full effect, most of ZTE's business can't continue. But technology needs a market too, and what happens next is hard to say.

Over the past year the world built 1.472 billion smartphones, the vast majority of them in China. Of those, 450 million stayed in China, 520 million went to the United States and Europe, and 124 million went to the emerging Indian market.

ZTE is not one of the leaders in the phone business. At 45 million units a year it ranks only ninth, behind Samsung, Apple, Huawei, OPPO, vivo, Xiaomi, LG, and Lenovo. A small share of the phones it makes are sold in China under the Nubia and ZTE brands; more than 90% go overseas.

The future of that business — 45 million phones a year, 36 billion yuan in sales — is now in doubt.

On April 15, US time, the US Department of Commerce, citing ZTE's illegal export of goods to Iran, barred American companies from selling parts, goods, software, and technology to ZTE Corporation — a seven-year ban running until March 13, 2025.

ZTE treats this as its top priority.

After the ban was announced, China's Ministry of Commerce said it would take the necessary measures to protect the interests of Chinese companies, adding that ZTE works with hundreds of American companies and has done much to create American jobs.

The day after the ban was issued, ZTE told staff in an internal email that it had set up a crisis response task force. At the same time, trading in ZTE's shares was suspended in Hong Kong and Shenzhen. In a statement, ZTE said it was making a full assessment of the possible impact on the company and was in active contact with all parties.

On Wednesday, ZTE announced that it would delay disclosure of its first-quarter 2018 results and that its shares would stay suspended. A photo also circulated on Weibo showing ZTE founder Hou Weigui at an airport, pulling a suitcase, with three staff members alongside him — reportedly running around over the penalties against ZTE.

The components the US has barred from export to ZTE include core parts such as Qualcomm and Intel chips, so the seven-year ban also hits 5G communications, now at a critical stage of development. The electronic technology covered includes the Android operating system and the software that goes with it.

What alternatives does a smartphone company have once it is cut off from American technology?

Smartphones are a highly globalized business, and chip technology can't be fully separated from American companies

Today's smartphone usually has a screen a bit over 5 inches and weighs around 200 grams.

It represents global division of labor better than aircraft manufacturing does. Boeing also builds planes through a global division of labor, but there the labor is what's spread around the world; the technology that is truly indispensable is still mostly in the United States.

Smartphones are dispersed at the level of the technology itself. Screens and memory come from Japan and South Korea, cameras from Japan; most of the main chips are designed in the US and made in the US or Taiwan. As for the operating system, there is no choice at all.

Like most phone makers, ZTE buys the vast majority of its chips outside, and leans especially hard on American companies. On the high-end Nubia line, for example, the CPU, the communications processor, and other main chips come from Qualcomm; the WiFi, GPS, RF, and power management chips come mainly from Qualcomm too; and the PA (power amplifier) chips come from Skyworks and Qorvo.

The teardown site myfixguide once broke down the chip suppliers behind the Nubia Z11 in detail:

• CPU: Qualcomm Snapdragon 820 (US)
• Memory: Samsung 4GB (South Korea)
• Flash storage: Samsung 64GB (South Korea)
• Audio amplifier: NXP TFA9890A (Netherlands)
• Audio codec: Qualcomm WCD9335 (US)
• Hi-Fi chip: Asahi Kasei AK4376 (Japan)
• Fast-charging IC: Qualcomm SMB1351 (US)
• WiFi chip: Qualcomm QCA6164A (US)
• NFC chip: NXP Q2204 (Netherlands)
• Camera module: Sony IMX298 (Japan)

Those are the parts that show up on spec sheets. Others never get mentioned at a launch event but are just as necessary to build a phone:

• Power management IC: Qualcomm PMI8996 (US)
• RF transceiver chip: Qualcomm WTR3925 (US)
• Multi-mode, multi-band power amplifier module: Skyworks 77629-21 (US)
• Quad-band power amplifier module: Skyworks 77807-4 (US)

For most of these chips ZTE has no substitute. From memory to CPUs, domestic Chinese chips hold anywhere from 0% to 22% of the market, depending on the category.

CPUs in low- and mid-range phones can be swapped for parts from MediaTek or Spreadtrum, but putting those chips in a high-end product is close to abandoning the product line: the Nubia brand and the premium it took years to build would vanish. ZTE's main overseas offering right now is the Axon series, which also runs on Qualcomm Snapdragon chips.

Perhaps, with intervention from some quarter, ZTE could get hold of Huawei's Kirin chips. But whatever the substitute, switching supply chains costs time, effort, and money. The low-level code a phone maker writes itself is matched to a specific chip, so changing chips means writing all of it again from scratch.

An industry insider who used to work at Huawei and knows phone supply chains told QDaily that switching suppliers for chips this critical takes at least a year to run smoothly, and that during it the chip supplier would have to station staff at ZTE to coordinate development and debug the code.

"Even with administrative intervention, how much effort Huawei would put in is a big question mark. This would mean direct cooperation between China's two largest telecom equipment makers, and Huawei's phone market share is far ahead of ZTE's. Is it really willing to help raise a competitor?" the insider said.

On chip stockpiles, a phone maker usually keeps about a month's supply of its own, and its component distributors keep another month's. ZTE's 2017 annual report puts its raw material inventory at about 17% of that year's total purchases of goods and services, which works out to roughly a month and a half of stock in all.

Tang Chuan, an analyst at Sinolink Securities, says the current situation is bad for China's domestic electronics industry but also opens an opening: new money may flow into related industries and push technology upgrades along.

Chip development, though, is never quick. It takes sustained investment and iteration. The K3 phone processor Huawei first launched in 2009 did not come close to Qualcomm on performance until around 2016, and it is still far behind Apple's in-house processors.

ZTE cannot wait out nearly seven years. Even one year is too long, in fact — sales channels won't wait. When Nokia switched to the Windows Phone platform, a gap of more than six months cost it its future outright, and ZTE stands on far weaker ground than Nokia did in 2010.

Hardware isn't the only problem, either.

Without direct support from Google, Chinese Android phone makers would have to give up overseas markets

Reuters reported on the 17th that ZTE was talking to Google about the impact of the US government ban, but that as of Tuesday morning local time the two companies had still not decided whether ZTE could keep using Android.

Android is an open-source operating system, so ZTE can run the standard version on its own. Since no commercial exchange is involved, that may fall outside the ban.

But the full Android experience also includes Google's proprietary mobile services — the Play Store, Gmail, Google Maps, the Chrome browser, and so on. None of them are open source; a manufacturer needs a license from Google and has to pay to use them.

Outside China, Google's internet services hold an overwhelming share of the market, the app store above all. Without them, essentially no overseas sales channel will carry a phone in volume.

Google controls more than its own services. During his years at Google, Andy Rubin, the father of Android, pushed through a vast and complicated framework of apps and services called GMS, and most of the apps popular overseas need GMS to run.

Yelp, the restaurant review app popular in Europe and America, or Hong Kong's OpenRice, won't work on an Android phone without GMS. They pop up a message along the lines of "xxx needs Google Play services to run; your device isn't supported."

Through that framework Google keeps a firm hold on app distribution — the most important gateway for traffic on an Android phone. It is also one of Google's sources of revenue.

To use these services, phone makers give up the potential revenue from running their own app store and pay various licensing fees on top; leaked figures put the cost at around $1 per device.

An Android phone maker that can't use Google's services has no overseas business left. And by ZTE's own account, 90% of its phone sales are overseas.

The ZTE ban is a continuation of ZTE's 2012 illegal exports to Iran

The Islamic Revolution broke out in Iran in 1979, and Islamist extremists, sheltered by the newly installed revolutionary government, seized the US embassy in Tehran and took 52 American diplomats and civilians hostage.

The US imposed economic sanctions on Iran that same year, and in 1995 widened them to cover international trade, finance, nuclear materials, crude oil, shipping, and weapons — and to bar foreign companies from doing business with Iran.

The Commerce Department's current sanctions on ZTE rest on several resolutions dating back to 1995.

The US government obviously cannot govern the business a Chinese company does with a third country, but it can demand that American technology not reach other countries by way of Chinese companies.

This time, again, the instrument is a ban.

As early as 2012, the US government opened an investigation into ZTE for exporting to Iran without authorization, in violation of US trade sanctions on the country. A document marked confidential but widely circulated — an internal ZTE file — described how the company broke the ban, reselling technology supplied by American companies to Iran and other countries.

After obtaining the document, in March 2016 the US imposed preliminary sanctions on ZTE, requiring any company selling American parts or equipment to ZTE to apply first to the Commerce Department for an export license.

Talks with the US side then paid off, and the US government announced it would suspend the sanctions, granting ZTE a three-month temporary export license. A year later ZTE reached an agreement with the Commerce Department and agreed to pay a $1.19 billion fine — the largest criminal fine in the history of US sanctions cases.

Over that period ZTE wrote to the Commerce Department repeatedly, saying it had begun an internal investigation and a clean-up, and handing over a list of 39 employees to be disciplined, to show it was taking the agreement seriously. The department in turn agreed to let ZTE defer payment of $300 million of the fine.

This February the Commerce Department wrote to ZTE asking for the current jobs, responsibilities, and pay of those 39 people. ZTE then admitted that its earlier letters had been false: it had fired only 4 of them, and of the remaining 35, all but one — 34 people — had collected their full 2016 bonuses.

Given that conduct, the Commerce Department notified ZTE that it would issue the ban. In the exchanges that followed, ZTE admitted falsifying information but denied any intent to deceive the US government, and asked in return: "Why would ZTE need to risk an additional $300 million penalty and being put on the export denial list, just to protect these 39 people?" ZTE also asked the US to hold off on the ban until it could submit its own internal investigation.

"ZTE misled the Department of Commerce," US Commerce Secretary Wilbur Ross said in a statement. "Instead of reprimanding ZTE staff and senior management, ZTE rewarded them. This egregious behavior cannot be ignored."

In the end the reprieve ZTE hoped for never came. The Commerce Department reinstated the restrictions on the company that the 2017 agreement had set aside.

Beyond ZTE's smartphones, the ban will hit its telecom business, which brings in more of its revenue

The world's fourth-largest and China's second-largest telecom equipment maker, ZTE has businesses spanning wireless networks, optical transmission, data communications, and phones. Of the 108.8 billion yuan in revenue it took in during 2017, 58% came from supplying carrier networks with communications equipment of various kinds, 32% from consumer electronics — that is, phones — and the rest from its government and enterprise business.

But ZTE depends heavily on chips across several of its main businesses.

CCID Think Tank, a body under the Ministry of Industry and Information Technology, analyzed ZTE's 2014 annual report and concluded that ZTE bought $5.9 billion of chips that year, $3.1 billion of them from the US — 53% of the total. Broadcom was ZTE's largest supplier; other foreign companies among the top ten by contract value included Hynix, Texas Instruments, MediaTek, and Skyworks.

In its latest annual report, for 2017, ZTE disclosed that purchases from its largest supplier came to 3.169 billion yuan, or 5.46% of the group's total annual purchases, and that purchases from its top five suppliers came to 10.612 billion yuan, or 18.28% of the annual total. It did not name the suppliers.

But analysts at CICC believe that among the core components of ZTE's communications equipment, some base-station parts come 100% from American companies. Analysts at CITIC Securities point out that because ZTE's baseband chips, RF chips, memory, and most of its optical components all come from the US, the ban will do serious damage to deliveries on ZTE's existing orders and to winning new ones, with both shipments and payment collection expected to suffer.

None of this should be unfamiliar to ZTE. After the Commerce Department's preliminary ruling in 2016, ZTE and its affiliates were immediately barred from buying American suppliers' products directly or indirectly, and even phone, email, and on-site technical support stopped at once.

CCID Think Tank's research groups the ZTE telecom equipment components now constrained by American suppliers into the following categories.

Wireless network products. On baseband chips, ZTE supplies its own 2G and 3G baseband chips and digital IF chips, but 4G and above still has to be developed on high-speed FPGA chips from Xilinx and Intel; RF chips come mainly from Skyworks and Qorvo, and power management chips mainly from companies like Texas Instruments.

Optical transmission products. The picture on chip development resembles that for wireless network products: ZTE supplies its own chips for some low-end product lines, but mid- and high-end optical switching and multiplexing chips for 10G/40G/100G and above come mainly from companies like Broadcom, and optical transceiver modules mainly from Oclaro, Acacia, and the like.

Broadband access products. XPON central-office and terminal chips, ADSL central-office and terminal chips, CMTS central-office and terminal chips, and wireless router chips come almost entirely from Broadcom.

Data communications products. On routing and switching chips, ZTE supplies its own low- and mid-range chips, but high-end switching and routing chips such as 100G depend mainly on Broadcom; Ethernet PHY and high-speed interface chips still come entirely from Broadcom, PMC, and others.

On this, Huatai Securities researcher Zhou Ming notes: "As things stand, high-end electronic components from American companies — CPUs, FPGAs, AD/DA converters, RF chips, high-speed optical modules, DSPs — are all but irreplaceable anywhere in the world."

According to figures from the Semiconductor Industry Association (SIA) and World Semiconductor Trade Statistics (WSTS), global semiconductor sales came to $412.2 billion in 2017, with American semiconductor companies accounting for 46% of that.

In the Chinese market, American companies held 51%. In fiscal 2017, 21 US-listed semiconductor companies — among them Micron, Qualcomm, Broadcom, and Texas Instruments — had combined revenue of $223.1 billion, more than 37% of it from China.

But technology needs a market, and a semiconductor trade war won't produce a one-sided victory

The Paper reports that Douglas Jacobson, the export-control specialist at the law firm Jacobson Burton Kelley who represents ZTE, believes the Commerce Department's latest sanctions decision will certainly hurt ZTE's sales worldwide, and that ZTE will find it hard to get the decision reversed.

CCID Think Tank, the body under the Ministry of Industry and Information Technology, had earlier said US sanctions would "deal ZTE a devastating blow" — and yet ZTE still reached a deferred-penalty agreement with the Commerce Department.

If the sanctions are part of a trade war, though, where it goes next is hard to say.

A senior Commerce Department official said in an interview on Monday that the action had nothing to do with the broader intellectual property investigation into China. The department's investigation into ZTE's export violations goes back to 2012.

But as friction between the US and China sharpens, no one seems to believe there is no connection. Reuters put it plainly in its headline: "U.S. ban on sales to China's ZTE opens fresh front as tensions escalate."

The timing of the ban is suspicious too. After Trump announced trade measures against China, including the Section 301 investigation, China said on April 5 that it would put a 25% tariff on a range of American farm products, soybeans among them. Almost at the same moment this week that the ZTE sanctions surfaced, American-grown sorghum was added to the Ministry of Commerce's list of products facing extra tariffs.

For years the US government and press have criticized tech companies like Apple for moving production overseas.

But the ZTE case shows once again which companies actually hold the core technology in those supposedly offshored industries.

OPPO, vivo, Xiaomi, and even Huawei, which has chip design capability of its own, cannot get free of working with American companies. For the great majority of Chinese telecom equipment makers, the risk of an escalating trade war never goes away.

The ban is hurting American companies too. After the US announced the export ban, the share prices of ZTE's American component suppliers fell across the board. On April 16, Qualcomm dropped 2.1%, Broadcom 0.4%, and Intel 0.21% — on a day when the Nasdaq rose 0.7%.

Smaller suppliers were hit harder: Acacia plunged 35.89% that day, losing $400 million in market value. Lumentum fell 9.4% and Oclaro 15%.

Much of the technology may sit overseas, but China has the largest market of smartphone buyers: a third of the world's smartphones are sold here.

This market's total size and the speed at which people replace their phones both beat every other region in the world. Apple holds part of the high-end segment; apart from that, no American technology company can reach these users without selling — or licensing — its technology and chips to Chinese companies.

Losing a third of the market would be an unimaginable disaster for any industry, and all the more so for chips, where the upfront investment in research and production is enormous.

A trade war has plenty of room left, and worse escalations are possible. In today's globalized market, this really is something that does no one any good.

Reporter Yang Kuan also contributed to this article.

Cover image / Pinterest, Wikipedia