THREE
Huawei
Technology Dictates, but Politics Still Counts

Use the countryside to surround the cities.

—Strategy attributed to Mao Zedong

IN EARLY NOVEMBER 2010, executives at China’s Huawei Technologies anxiously awaited the fate of their bid to upgrade the wireless network for Sprint Nextel, one of the largest telephone companies in the United States. With worldwide sales of roughly $30 billion a year, Huawei already provided some of the world’s most advanced telephone switching gear to 45 of the world’s top 50 telecom companies, including BT (British Telecom), Orange (part of France Telecom), Vodafone Spain, Telefonica, and KPN, as well as carriers in a number of emerging markets in Eastern Europe and the Pacific Rim. The company had 60,000 employees, nearly half involved in R&D, and had taken on an increasingly international personality. “We used to recruit mainly in Beijing and Shanghai,” said Edward Deng, the company’s chief of European operations. “But now, we also recruit in New York, London, Paris, Canada, and Australia.”

Entering the Market Through the Back Door

But for all of Huawei’s growing reputation abroad, it had been forced to enter the U.S. market through the back door. Although Huawei was quietly generating sales in the United States worth around $400 million a year, its business was limited to small and medium-size enterprises. The major players—Sprint Nextel, AT&T, and Verizon—and the high-end contracts were effectively off-limits. No formal declaration excluded Huawei from the market, but every time the company tried to close a major deal, a discreet phone call from a U.S. government agency would warn the potential client that if it went to a Chinese company to manufacture its equipment, it risked losing its most valuable contracts with the U.S. government.

What was particularly galling to Huawei was the fact that the largest competitor in the field—Cisco Systems, with sales of $36.1 billion in 2009—had been manufacturing much of its equipment in China for years. Cisco was the main company involved in creating the first generation of equipment giving China access to the Internet, which came to be known as the Great Chinese Firewall. It was difficult, Huawei’s supporters argued, to see much difference between the two companies unless it came to who owned the stock. Opponents of the 2010 deal between Huawei and Sprint Nextel implied darkly that Huawei’s close connections to the Chinese military and government agencies might make Huawei vulnerable to pressure to insert spyware or even a “software bomb” into the vital communications networks of the United States.

By the time the Sprint Nextel bid emerged, Huawei was already experienced at dealing with America’s political sensitivities toward China, especially on the part of the Republican Party and Washington’s right-wing policy organizations, which were to a large extent still mentally rooted in the Cold War.

Ren Zhengfei, Huawei’s founder and chairman, had already made headlines in 2000, when the CIA flew into a rage over Huawei’s readiness to bypass international sanctions and sell a communications system to Baghdad. For its part, Huawei had seen little reason at the time why a Chinese company’s client list should be limited by what it saw as U.S. foreign policy interests. This was especially true to Huawei since Halliburton, the oilfield services company that was then headed by Dick Cheney (the future vice president of the United States), had purchased a subsidiary, Dresser Industries, which had sold $73 million worth of oilfield equipment and parts to Saddam Hussein’s Iraq regime through another subsidiary that it jointly owned with another major American equipment company, Ingersoll-Rand. (Cheney denied direct knowledge of the Iraq sale at the time, but Colum Lynch, reporting in the Washington Post, quoted two senior executives who had served under Cheney as saying that the company had no policy that they knew of that would have prevented them from doing business with Saddam’s Iraq.)

The flap over Iraq underscored a fact that was just beginning to dawn on American politicians, that although the United States might still be the world’s only superpower, it could no longer claim a monopoly in shaping international politics. The emerging markets—particularly China and India—still lacked the power to set policy themselves, but they were increasingly in a position to veto someone else’s policy plans. The new state of affairs was beginning to endow China with the political weight that it had long sought. For private businesspeople like Ren, it meant that the world had suddenly become a lot more complicated.

Hitch Your Star to a Global Brand: Huawei, 3Com, and Cisco

In 2002, Huawei had begun putting together a joint venture with 3Com, an American pioneer in developing wireless Internet routers, the switch boxes that enable computers to network together. Although 3Com was critical in launching the technology, it had had trouble keeping up with the fast-changing market.

The joint venture was intended to build network routers in Hangzhou and sell them in the United States. 3Com, founded in 1979, had entered the Chinese market in 1994 and built a business selling its innovative networking solutions to small and medium-size businesses worldwide. By 1995, it had a broad distribution network throughout China, but as competition from Chinese companies picked up, 3Com’s market share began to decrease. By the time that Ren approached 3Com’s CEO, Bruce Claflin, about forming an alliance, the company had slashed its staff from a peak of 10,000 employees to just 3,400. Although industry observers were convinced that Huawei wanted to gain access to 3Com’s technology, 3Com had lost so much staff and was under so much financial pressure that it stood to gain much more than it had to offer from access to Huawei’s technology and formidable capacity in R&D.

For his part, Ren wanted a recognizable global brand to make Huawei’s products more attractive to American and European clients. Most important of all, however, Ren and Claflin were mutually impressed with and liked each other.

OPPOSITION FROM CISCO

The joint venture soon ran into trouble when Cisco Systems, the market leader, filed a suit against Huawei on January 23, 2003.Cisco accused Huawei of violating its intellectual property rights by copying its software and some of the terminology in its user manuals. Huawei immediately removed the suspect products from the market, but Cisco then accused Huawei of trying to remove evidence. Ren suspected that Cisco was not as concerned about a few lines of software code as it was about the prospect of entering into long-term competition with a Chinese company that employed thousands of brilliant engineers who were hungry for success and willing to work for a fraction of the salaries paid in the United States.

At the time, Cisco, which had begun producing network routers in 1986, was the leader in the field. It had 68 percent of the market for Internet routers in China, compared to only 13 percent for Huawei. But Cisco was already beginning to feel pressure from the same competition in China that was driving Huawei toward the international market. China represented 5 percent of Cisco’s worldwide sales in 2002, but it was not clear how long that would continue.

Cisco’s suit was based on several lines of its code that had appeared in some of Huawei’s software. Huawei countered that it employed more than 10,000 engineers and didn’t need to copy anyone else’s software. Since Cisco was employing Chinese engineers itself, it was difficult to tell whether the code had accidentally slipped into Huawei’s software or had been intentionally copied. Eventually, Huawei admitted that some 2 percent of its routing operating software had come from Cisco, but Huawei insisted that the code had been accidentally introduced by an employee without the knowledge of Huawei’s top management. The suit was settled out of court. For Huawei, though, the fact that the suit had coincided with its developing relationship with 3Com was a signal that Cisco was determined to keep Huawei from competing directly in the American market.

3COM DROPS OUT OF THE PICTURE

Huawei eventually went ahead with its joint partnership with 3Com, which was called H3C (Huawei-3Com). Before long, 3Com was well on its way to changing from an industry innovator to a mere distributor of Chinese products to be sold in the United States. Huawei contributed 1,000 employees to the venture, while 3Com contributed only 50. After two years, 3Com exercised an option to buy out Huawei’s interest in the venture. As 3Com’s prospects steadily declined, a leveraged buyout firm, Bain Capital LLC, offered to buy 3Com for $2.2 billion. Huawei was a minority partner in the bid. The deal fell through when a group of eight Republican congressmen charged that it risked giving China access to anti-hacking software produced by a 3Com unit, Tipping Point. The congressmen eventually threatened to pass legislation outlawing the sale.

From Huawei’s point of view, the message from the 3Com fiasco was fairly clear: The effort to keep Huawei from competing in the American market had passed from debatable charges of violating intellectual property to one of national patriotism. If you could not compete on price, you could always raise the specter of a threat to national security. One of the most powerful human instincts, the closing of ranks to repel an invader, emerged as the next most powerful marketing tool in the campaign to keep Huawei from entering the American market.

National Security vs. the Outsider

In 2008, when Huawei competed for yet another contract, this time with AT&T, there was no hesitation among opponents about raising the specter of China itself as a potential threat to U.S. security. This time, the contract was worth just over $1 billion. At the last moment in the lengthy negotiations, according to a report by John Pomfret in the Washington Post, the U.S. National Security Agency— the secretive intelligence agency that is responsible for spying on telephone and electronic communications in foreign countries, especially China—had quietly threatened to exclude AT&T from lucrative future U.S. government contracts if it did not pull out of the deal. AT&T protested that it was more than capable of guaranteeing that the equipment would be safe to use, but it then opted for the path of least resistance and gave the contract to Sweden’s Ericsson and France’s Alcatel-Lucent.

Huawei then turned, in the summer and fall of 2010, to competing for a contract with Sprint Nextel. This contract promised to be much larger and more significant. While some companies were bidding as much as $8 billion for the contract, the word on the street was that Huawei’s offer was just over $3 billion.

To help it navigate the intricacies of Washington, Huawei hired Amerilink Telecom Corporation, a lobbying firm created in June 2009 by William Owens, a former vice chairman of the U.S. Defense Department’s Joint Chiefs of Staff. Huawei was Amerilink’s first and only client, and Owens hoped that his previous position on the Joint Chiefs of Staff would qualify him to guarantee safeguards against China using Huawei to slip spyware into the new system. Owens packed substantial credibility by himself, but he didn’t stop there. He subsequently hired James Wolfensohn, the former head of the World Bank, along with Richard Gephardt, the former majority leader of the House of Representatives, to bolster the team. Amerilink’s CEO and many of its executives had previously worked for major U.S. telecom companies and especially Sprint.

The investment in hiring Amerilink was enough to get Huawei past the starting gate and on to a final short list of six companies. It was not enough, however, to cross the barrier of suspicion that China’s military might try to use the opening to pull a fast one on U.S. defense. The contract ultimately went to Alcatel and Samsung, at a considerably higher cost than Huawei’s bid.

Although Huawei was not happy at the outcome, it was not exactly dismayed, either. The company issued a typically bland statement, saying simply, “Huawei has never researched, developed, manufactured, or sold technologies or products for military purposes.” The reaction in Beijing was less accommodating: “The U.S. reaction is too irrational and exaggerated the situation,” said Tu Xinquan, director of the China WTO Institute at the University of International Business and Economics.

The implicit message for Huawei was clear. In spite of the public rhetoric from the United States about free markets, business with the U.S. government is nearly always intensely political, and the old saying that all is fair in love and war is even truer when it comes to global business. Business at the level the multinationals play it is a no-holds-barred street fight in which anything goes.

It was a lesson that Ren and other Chinese private sector entrepreneurs had learned early on in their struggle to survive in their own domestic market during China’s turbulent transition from a politically connected, state-controlled socialist economy to one that was in the truest sense of the term a free market. In the coming struggle for the global telecom market, Ren suspected that he might be better prepared than the U.S. giants, which had themselves grown increasingly dependent on government contracts for their own survival and found themselves pleading more and more for Washington’s intervention when their own resources were no longer sufficient to close a deal.

Huawei’s Long March

For Ren Zhengfei, the journey that had led him to this point had been a heady one. Ren had begun his career as an officer in the Chinese army and eventually served as director of its Information Engineering Academy, the technical school responsible for the army’s telecommunications research. In 1984, at the age of 39, he retired as a colonel and went to work for the state-owned Shenzhen Electronics Corporation. Four years later, he took out a loan for $8.5 million from a state-owned bank and launched Huawei Technologies with a total staff of 14 people.

CHANGES IN CHINA’S APPROACH TO TELECOMMUNICATIONS

Ren’s decision to launch Huawei in 1988 coincided with major changes in China’s approach to telecommunications. From the period following the Chinese revolution (1949 through 1979), the telephone system was state-financed and state-owned. It was operated by the Bureau of Posts and Telecommunications (BPT), which came under the joint direction of the Ministry of Posts and Telecommunications and the Ministry of Electronics Industry. The goal was to provide telephone service to help the country’s overall economic development, not specifically to make money from the service itself. Roughly 90 percent of the funding came from the government and only 10 percent from actual users.

In 1979, private commerce was legally authorized in China, and by 1982, the government began opening up the telecom market. Non-state-owned private companies, which had previously been banned from telecommunications, were invited to compete with the state-owned companies. The industry gradually shifted from a not-for-profit operation to one that was increasingly profit-oriented. In order to guarantee rapid expansion, the government encouraged telecom providers to go into debt, promising to make the operations profitable in the future. To further speed the expansion, it made loans freely available. The result was a race to build telephone networks, and local equipment providers such as Huawei Technologies, Datang Group, and ZTE (Zhongxing Semiconductor Ltd.) emerged as local providers.

From 1990 to 1993, revenues for the industry increased 3.5 times and the number of subscribers more than doubled to 17.3 million. The number of residential subscribers more than quadrupled from less than 2 million to 9.4 million. The number of mobile phone subscribers increased by 354 percent. Internet and e-mail usage also soared. By 1993, China’s optical fiber trunk network had been increased to 24,000 miles, a 645 percent increase over 1990.

In order to avoid the high cost of buying foreign equipment, the BPT had established numerous state-owned subsidiary companies to manufacture equipment locally. Many of these companies were badly managed and produced equipment that was unreliable. Half the companies were on the verge of bankruptcy. Given the paternalistic traditions of state-run enterprises, however, the BPT couldn’t simply shut them down without facing strong resistance. It could, however, introduce competition from the private sector. In 1993, it opened nine telecom services to domestic private companies, to introduce leading edge technology into the industry. Foreign companies were not allowed to own, manage, or operate domestic telecom systems by themselves unless there was an urgent need to directly purchase foreign technology, to significantly increase China’s R&D, or in the case that the collaboration would lead to the introduction of advanced production techniques. The main foreign companies that became involved through partnerships with Chinese companies were Alcatel, Motorola China, Seimens, Nortel, and Ericsson. The largest domestic companies were ZTE, Datang, Wuhan Research Institute, Great Dragon Telecom, and eventually, Huawei.

FROM LOCAL TELEPHONE EXCHANGES TO ADVANCED NETWORKS

Huawei adopted a two-pronged strategy relying both on sales of foreign equipment and on developing its own technology. To get the business moving, the company began importing telecom switches from Hong Kong and selling them to local networks. It did not take long for the competition to catch up. Ren was soon competing with at least 100 companies in Shenzhen alone.

But Ren realized early on that developing his own technology was the key to creating a sustainable business. From the beginning, Huawei committed more than 10 percent of its revenue to R&D. Within a year, it had designed, manufactured, and was aggressively marketing its own private branch exchange (PBX) products. At the time, roughly 200 domestic companies were producing telephone exchange switches, mostly for hotels, mining operations, and small enterprises. The average switch was capable of handling up to 2,000 connections, and the most reliable models were still being produced by foreign multinationals. Ren wanted to aim higher than that, but Huawei was already strapped for cash as a result of its extraordinary investment in research. To make matters worse, the banks, having suffered through the failures of so many state-owned companies, were reluctant to make loans to a private startup with no political connections.

Ren nevertheless decided to push ahead. He gambled the company’s future by taking out loans on the unofficial “gray market,” at a potentially crushing 20 percent interest rate. Plowing the money back into development, he managed to produce the company’s first 10,000-port, C&C08 switch, capable of handling five times as many connections, in 1994. Developing the switch cost Ren more than $10 million, but it was worth it. The gamble coincided with a massive government push to expand telecommunications at an even faster pace.

Not satisfied with merely producing switches, Huawei next moved into building signal transfer points (STPs), a critical component of narrow-band telephone systems, which until then had mostly been the preserve of the large multinationals. Since the multinationals, specifically Alcatel and Nortel, had locked up the market for the telephone networks in China’s most important cities, Ren decided to focus on the provinces that the major players considered too remote and undeveloped to bother with.

In a sense, Ren was following a strategy familiar to players of the game Go, and also adopted by Mao, of gradually encircling the target before finally closing in and enveloping it. Mao had referred to it as “using the countryside to encircle and then expand to the cities.” In Ren’s case, it meant counterintuitively focusing on regions that did not seem promising to the major brands. When Ericsson sent three or four salespeople to talk to officials in Heilongjiang Province, Huawei sent more than 200. Huawei also made an extraordinary effort to provide the kind of fast and reliable service that foreign companies were not in a position to deliver. Huawei implemented its first STP equipment in Yinchuan, the capital of Ningxia Province, in 1996. The Ministry of Posts and Telecommunications monitored the implementation of the system carefully, and it provided proof that Huawei’s equipment could do the job as well as foreign manufacturers. Before long, nearly all the provinces had signed up to buy STP equipment from Huawei, and by 2005, Huawei had captured a third of the Chinese market.

While many Chinese companies were content to copy Western products and then sell them at reduced prices, Huawei increased its efforts to develop its own technology. When the world telecom market reached a low point in 2002 and most companies were cutting back, Huawei increased its R&D investment to 17 percent of revenues. By June 2005, it had set up ten research institutes and was sharing technical know-how with Texas Instruments, Microsoft, Sun Microsystems, Motorola, IBM, and Intel. Huawei was averaging three new patents a day and giving substantial bonuses to engineers who developed the best ideas. It had soon accumulated more patents than any other company in China.

Ren had clearly targeted the leaders of the global industry, and he not only intended to catch up to them—he wanted to surpass them. At the same time, Ren emphasized the importance of designing products that specifically answered the customer’s needs rather than producing technology for its own sake.

Huawei Goes Global

Although Huawei turned out to be extraordinarily successful in its domestic market, Ren sensed that the company needed to continue expanding or it would be in trouble. In fact, one of Ren’s most characteristic obsessions was fear that the market would evolve faster than Huawei’s ability to keep up with it. Huawei had tentatively begun to sell its products internationally as early as 1996, but this was mostly in developing markets, such as Brazil, South Africa, Ethiopia, and Yugoslavia. Its main focus had continued to be on China, but Ren was increasingly aware that the market in China was becoming saturated.

The biggest foreign client that Huawei had tried to sell to was Russia, but the company encountered the natural skepticism that one country in the Eastern bloc is likely to feel about the technology coming from another. Ren countered Russian doubts by flying potential clients to Beijing, Shenzhen, and Shanghai to see China for themselves. Despite that effort, Huawei’s first major foreign sale turned out to be to Yemen and Laos in 1999. Two years later, in 2001, its efforts to impress Moscow paid off. Huawei won a $10 million bid to sell GSM (global system for mobile communications) equipment to the Russian government.

The need to step up its overseas expansion became apparent in 2002, just two years after the worldwide dot-com bust. Huawei’s sales in China had risen to $2.2 billion, but its domestic market share was shrinking by 21 percent a year. It was increasingly obvious to everyone that the domestic market now really was becoming saturated. Huawei’s international sales were only around $500 million, or roughly 18 percent of its total sales. Ren decided that it was time to make a major effort at going international. By 2004, just two years later, international sales accounted for 40 percent of the company’s revenue. The only area that seemed off limits for major contracts was the United States.

HUAWEI’S INTERNATIONAL SUCCESS

Huawei had been cautious about trying to enter the U.S. market, even though it had created an institute in Silicon Valley in 1993 to explore chip production. But its success outside the United States was startling. By 2005, the company was providing telecom and Internet switching equipment to more than 30 of the world’s top 50 telecommunications companies. British Telecom had selected it as one of its eight preferred suppliers for its 21st Century Network. Huawei’s sales still added up to only 17 percent of those of Cisco, the market leader, but it had clearly marked itself as a global contender.

A major breakthrough in the European market had been Huawei’s successful sale of equipment to what later became Neuf Cegetel, which is now owned by SFR, France’s largest alternative telecommunications supplier (and second largest telecom supplier) and second largest mobile and fixed-line telephone provider. In 2001, Neuf was on the point of launching a program to provide a competing broadband Internet network for all of France. A final short list of manufacturers had already been decided upon when Huawei asked for a chance to make a last-minute bid. Michel Paulin, Neuf’s CEO, was impressed by Huawei’s low-cost offer and even more by its determination, but he was also concerned that China was geographically on the other side of the planet, and he was uncertain about Huawei’s ability to deliver on time in Europe.

To break the ice, Huawei offered to build part of the network and run it for three months while Neuf’s engineers tested it for free. That offer clinched the deal. Huawei won the contract and quickly became an integral part of Neuf’s strategy to undercut the pricing of its chief competitor in France, Orange. More important, Huawei had successfully positioned itself to be ahead of other competitors when Neuf inevitably expanded its system from 40 gigabytes to 100 gigabytes.

Neuf had based much of its business strategy on providing the simplest interface possible to French consumers who were likely to be easily confused by computer and mobile phone technology. What impressed Neuf’s Paulin the most was Huawei’s readiness to listen to Neuf’s requirements and then to deliver exactly what was required.

Huawei’s flexibility and responsiveness was not an accident. Early on, the company had gone out of its way to hire local talent rather than relying solely on Chinese executives. It outsourced much of its hardware installation and some of its services to local partners. But it also managed to maintain high standards of quality. François Paulus, who headed the network division at Neuf, noted, “When we first saw Huawei, we couldn’t believe that a Chinese company could match an occidental one—we were wrong. Their technology was better and they were 30 percent cheaper.”

HUAWEI TARGETS THE U.S. MARKET

That kind of attention to detail still hadn’t managed to get the company a frontline position as a provider of cutting edge equipment to America’s top telecom networks. United States government opposition had effectively killed the Sprint Nextel deal, but Huawei executives did not seem overly upset. Charlie W. Chen, who headed Huawei’s U.S. operations, told the Wall Street Journal in the days leading up to the final decision about the deal that Huawei was adopting a long-term strategy. “We are not in a hurry to win any significant or big project,” he said.

In fact, Ren seemed intent on using the same strategy that he had used to conquer the Chinese market: Go for the smaller players first and gradually encircle the actual prize, until it became apparent to the target that there was nowhere else to turn. Only this time, instead of encircling a city, Huawei was signing up nearly every telecom system outside the United States. If it continued the kind of investment in R&D and innovation that it had done in the past, Huawei figured, even the major players in the United States would eventually have no other option but to open their doors to the best technology.

Ren had developed a number of guiding principles that had helped Huawei to grow while other companies fell by the wayside under the pressure of an increasingly competitive market. His most important insight was to make Huawei develop its own technology. The policy created cash flow problems at different intervals, but it put the company ahead of the technological curve in a fast-changing industry.

As previously stated, in developing his business, Ren applied Mao Zedong’s strategy of starting in the countryside and gradually surrounding the cities. With few political connections at the beginning, he dispatched hundreds of sales personnel to China’s poor interior provinces, which the established multinationals hadn’t thought worth bothering with. As the company grew stronger, he moved into the more established urban areas. Applying the same principle along a different axis, he built a reputation for the company with relatively basic technology, and as the company grew stronger, he moved into increasingly sophisticated areas. Approaching the American market, Huawei established a strong reputation for design and effectiveness of cell phones and other basic consumer electronics and sold its most advanced networking equipment everywhere except America. As Huawei’s technology grew stronger, Ren sensed that eventually the American market would either have to open up to him or satisfy itself with paying more money than it needed in order to have second best. Huawei sensed that the market trend was in its favor.

In a sense, Ren, a former army officer, had applied another of Sun Tzu’s principles. “Military tactics are like water,” Sun Tzu had said. “As water shapes its flow according to the ground, an army wins by relating to the enemy it faces and adapts to the conditions of the environment and modifies its tactics according to the enemy’s situations.” In Huawei’s case, the principle called for paying special attention to forming the company’s production to the client’s needs, even if it meant hiring engineers who were not necessarily stars but were likely to be more sensitive to the vision of its customers. As Huawei’s breakthrough in the French market showed, the company also placed an emphasis on being more flexible and moving more quickly with more innovative proposals than its competitors.

But by far, Huawei’s most important advantage was its decision to invest heavily in R&D. As shown in Chapter 4, good management can turn improperly run companies around in a stable environment, but when technology begins to evolve quickly, even the bestrun company is likely to find itself in uncharted waters if it is relying on others for its technology.