Acquired - Huawei

0:00Interest for tonight. Oh yeah, I wrote up like a little like thing that's based on exactly what you texted me that I kind of like the idea of. Great, great. What I'm thinking isn't telling you if you like this. Welcome to season five episode one of acquired the podcast about technology acquisitions and IPOs. I'm Ben Gilbert and I am the co-founder of Pioneer Square Labs, a startup studio and venture capital firm in Seattle.

0:34And I'm David Rosenthal, and I am a general partner at Wave Capital, an early stage venture capital firm that focuses on marketplaces based in San Francisco. And we are your hosts. Today, we are covering China's largest private company, Huawei. The company is the second largest smartphone manufacturer in the world. Now, they're only behind Samsung, and they recently pulled ahead of Apple. They also happen to be the world's largest telecom equipment manufacturer among other things. Now, David, the company has had a pretty wild last 12 months. That would be putting them out. Yes. Barred from doing business with US companies, federal prosecutors have filed charges of wire fraud and their CFO was arrested upon landing in Canada last year.

1:23Oh, and the layoffs last week of hundreds of workers in the US went down amidst the trade war. So what is going on with this company and how did we get here? Yeah, well, that's what we're here to talk about. And this is going to be fun. This is a little bit of an experiment for us here at acquired. This is obviously not an acquisition.

1:41nor an IPO. And in fact, there is an interesting ownership structure of Huawei, which we will get into. But we felt like this is such an important moment for tech for international relations, you know, critical for all of us to really dig into and understand. And we certainly wanted to. So. And to understand it's a thing that I didn't understand before starting to do this research. And I would imagine most, most folks in the tech ecosystem kind of feel the same way. All right.

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4:32All right David now on to the episode and as you put it well, I think in the pre show We don't actually know how this one's gonna turn out and that's pretty exciting for us here required. Yeah, a little bit nervous. Yeah, but makes it all the more interesting All right, well history and facts of Huawei we rewind as we so often do here on acquired back to the early 1980s. It was a great time. I was Being born. Shortly after that, it's been important part of the episode. Most important part of the episode. But we just...

5:08And we recall back to a lot of the same themes we talked about in our Tencent episode, if you remember that. And that was both Shenzhen, the city in China, across the bay from Hong Kong and Deng Xiaoping and the opening up of China and the cultural reforms after Mao and the cultural revolution that would lead to China becoming the economic, be the first steps in China becoming the economic juggernaut that it has turned into today, both economic and technological juggernaut. As we said, this is a few years after the Cultural Revolution. Dang has taken over leadership of the party and he has seen and lived through all the turmoil of the Cultural Revolution and he believes that

5:52China needs to move forward, and he seizes the Communist Party's 12th National Congress, which they do every five years. It's the big five-year planning event that the party does in 1982, as the moment that he is going to announce his vision for the future of China. Again, we talked about this on the Tencent episode, and what he sees is China as the system in China as being socialism in communism, but with Chinese characteristics.

6:20And what he means by that is he wants to introduce a market economy back into China and introduce in a small way capitalism. And he has a very specific idea in mind. He has the city of Gengen has a special economic zone that is going to be the test bed for this idea of keeping China as a communist political system but reintroducing capitalism and the market economy.

6:47It's amazing. I mean, looking at that sort of declaration of the special economic zone and the, you know, 40-year effects that it's had on that city and so much innovation has come out of Shenzhen. Yeah. Well, and it's like, this is such a visionary and crazy idea at the time that you could mix communism and capitalism. The city is going to have a different economic structure. Like the economy in this area is going to be different than that of the rest of our nation.

7:17Yeah, yeah, completely. And obviously, the experiment was a success. But in attendance in 1982 at that National Congress, that very National Congress, was a relatively low level engineering core director in the Army, in the People's Liberation Army of China whose name was and is Ren Zhengfei.

7:40Ren is better known today as the founder and CEO of Huawei. But back then, he was a long way from those heights. So who is Ren? Well, one, he's a very witty individual. He's been a little bit of a recluse at least from Western media over the last few decades. But with all the events around Huawei over the last few months, he's kind of come back out of seclusion and has given many interviews to Western media and Eastern media. He's really a very, very smart and witty individual. Yeah, and I would define him as reclusive except when he feels his company is misunderstood.

8:20Yeah, just to give you a little taste, we'll link to a few interviews with him. You can find on YouTube and other sites online. But he was asked by Bloomberg in one of these interviews, how he feels about all the action that the US has taken against his company. And in particular, how it's going to impact these bands, the smartphone division. And he says, this is the quote, we might miss our growth target, but we are still growing.

8:46being able to grow in the toughest battle environment, that just reflects how great we are. That gives you a little flavor for Ren. So who's Ren? He was born in the 1940s, in rural southern China.

9:00His father had actually been college educated, which was incredibly rare for that time and place. Both he, Ren's father, and his mother were schoolteachers. And Ren ends up going to college as well, himself. He studies civil engineering at the Institute of Civil Engineering and Architecture in Quang Jing. After college, he works as a civil engineer for a few years. But then, of course, shortly after joining the workforce, the cultural evolution happens.

9:25Ren signs up. He joins the PLA. As an engineer, he gets put in charge of a really glorious assignment. He gets sent to a remote part of the country in Central China, and he gets put in charge of setting up a synthetic fiber factory. He ends up doing...

9:43Well enough at that and succeeding at setting up and managing this factory that he gets rewarded by the army he gets sent to the the country's national science conference in 1978 then he goes back and he continues working working at the factory and and then in 1982 because he succeeded so much that is how he lands himself the invite to this really prestigious you know national congress and historic congress where we're done helping announces you know the opening up of China So he's there, he's in the audience and, you know, he's inspired by Dungan and this vision and the leader and he decides he needs to...

10:19he needs to follow this call and become an entrepreneur. So he leaves the army very shortly thereafter and he moves to Shenzhen. He works briefly in the oil industry. He works for the Shenzhen South Sea oil corporation, which he realizes that the oil business is not for him. He's an engineer. He wants to work in engineering. He wants to work in technology, but that was his path to Shenzhen. So at the same time, now this is the mid-80s, the Chinese government has is trying to modernize all of the technical infrastructure of the country. And one piece of the infrastructure that is severely under invested in is telecommunications infrastructure. So what's that at the time? You know, there's no mobile telephones. There's no wireless industry. These are all fixed line television switches. Yeah, PBX. So the government is trying to

11:17find ways to import telephone switches into the country. And so Ren sees this. And of course, he had been part of the army and part of the party. And so he's now finds himself in Shenzhen. And he says, you know, maybe I can start a company to start importing these, there's this great demand for telephone switches. And maybe I can do that here in Shenzhen. So a couple of years into his job, he leaves in 1987. And he starts a firm, along with five other co-founders, to do just that import.

11:46PBX switches and resell them import them from Hong Kong and resell them in China. And famously as the story goes he starts it with only $21,000 RMB which was about $5,000 at the time. That's a debatable whether that was actually true but that is the law. You know it's crazy thinking about trying to put yourself in his shoes at this time. You only recently heard that this thing was Not only legal but possible, starting a company and becoming an entity that generates a profit and performs this private sector activity. And become an entrepreneur when entrepreneurs were persecuted during the Cultural Revolution, and you were a member of the army during that time. Right. Yeah. Not only was this thing illegal, which here in the US, the thought of doing something illegal can totally cross your mind, and you can still do it, but this was one step further where

12:43you know it's something that that was so culturally shunned that no one would sort of dream of doing it you know you blend ethics and religion and legal all into one and it the result is like you just don't perform that activity and it just a couple of years later here he is getting a band of people together to start a profit generating corporation just another window into what must have been going through his mind at this point in time He decides to name the company, of course, as we know Huawei. Well, where does he come up with the name Huawei? Well, Huawei means China and Wei means achievement. So the name of the company that he chooses is China Achieving. It's a good name. It's a good name. It's a good tech, especially for the time.

13:29Yeah, but you can see I mean coming from the army having been literally there in the audience when Deng Xiaoping is announcing the socialism with Chinese characteristics in the future in this vision for what China's both, you know, economy and politics are gonna be for the next 40 years. It's all wrapped up in this. Yeah, you'll notice he didn't name it telephone switch ink. It's quite the vessel to be able to do whatever he wants within.

13:55So the initial aim of the company, of course, as we said, is to import these telephone switches from Hong Kong and resell them in China, which they do, and they do very successfully. And they follow a playbook that Renhead had seen as part of the military in China. And that is that they start in rural areas, and they come to dominate rural telephone networks and selling to small villages in the countryside. And then they build up from there, and then they sell into cities.

14:23And the years go by and they become quite a large importer of this technology into China. But he doesn't really want to stop there. The ambitions are to build a big company and of course to achieve and for China to achieve the way that they're going to do that and going to do that on an international large scale isn't just to import technology. It's to build and develop their own technology internally. So he starts building alongside this import business.

14:53a pretty strong R&D and engineering group that grows to about 600 people over the first couple years of the company and that's crazy you know I mean here you have this this again this this import business that has developed this R&D group of 600 people alongside to build their own technology the like pattern matching radar going off in my head reminds me of shoe dog where Nike started as the blue ribbon shoes, and they were importing only Tsukka Tigers and reselling those. And you'd go to your blue ribbon guy to get your own Tsukka Tigers. Then it was this big jump to go and start actually doing the R&D and manufacturing their own shoes. I feel like I don't know as many recent examples of companies that started purely as an importer and then sort of switched the product that they were selling to be their own, but it keeps popping up in things from the 80s. Well, it's funny.

15:43technology now is such an intellectual property driven business where it's really hard to do that. Now, of course you could argue and lots of people do that it was back then as well. And Huawei played fast and loose with the intellectual property of the gear that it was importing, but it wasn't quite like it is today. That's fair point. So about five years later in 1992, Huawei, the fruit of all of this R&D investment that they've been making, they introduced their first product on their own, the CNC08 digital telephone switch and they introduce it into the Chinese market. And it completely dominates. It has the largest switching capacity of any product that was available in China at the time. Now, of course, Huawei had a large say in what other products were available in China at the time. But most importantly, they sell it for about a third the price that

16:35the imported switches are selling for. So as you can imagine, this comes to just dominate. And so very quickly, Huawei grows into a very large company domestically. But again, the scale of Ren's ambition is not just to build a large company domestically. He wants to bring this and the technology that they're building within China out to the rest of the world. So pretty quickly they're after in 1996.

17:00They begin selling this switch that they've developed to other telephone carriers in other countries outside of China. First, they go to Hong Kong back across the bay from, you know, they're originally importing networking gear from Hong Kong. They're now selling their own gear back to Hong Kong. From there, they go to Russia and Africa.

17:21And things really start to work right around the same time, and this is the mid-90s. Wireless is finally becoming a thing, and Huawei starts investing heavily in building networking gear for wireless telecoms as well. And pretty quickly, they become the largest CDMA equipment provider in the entire continent of Africa.

17:40This really starts to lay the groundwork for that when I was introducing the episode, saying that they're the largest telecom equipment manufacturer. We'll get into this later, but they have these three business lines, and this is still a huge one for them. These telecom carrier networks business that they make 5G equipment now, but they've made basically every generation of equipment that goes on cell towers and is used in the backbone of cell phone technologies since the mid-90s.

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19:11which is exactly why more than 16,000 companies today run on Vanta companies like ramp cursor and snowflake all stay audit ready and catch the risks that crop up between audits across every vendor every AI tool the whole environment and that's the real value.

19:29trust has to be continuous now, which is why Vanta automates your security, your compliance, and the work to earn and prove trust. We're huge fans of Vanta over here, and literally hundreds of acquired listeners have become Vanta customers at their companies over the years. So you can get $1,000 off Vanta at Vanta.com slash acquired. That's V-A-N-T-A dot com slash acquired for $1,000 off and just tell them that Ben and David sent you. So the question you might ask you to we've been telling this story of grand international scale ambition from the unlikeliest of places beginning in the early 80s in Chenzhen. You have to wonder a little bit like how did this unlikely story unfold besides certainly hard work and ambition and innovation at Huawei. How did they come within the span of a decade to become

20:21the largest wireless telecoms gear provider to countries completely outside of China. And here I thought you were just going to glaze over that, David. Yeah. Well, you know, if you remember back to what I was saying about how it was a strategic initiative of the government to modernize telecommunications networks within China, when they found Huawei and ran as a former, you know, PLA member and Huawei, literally meaning China achieving Well, the government thought this is a pretty good vehicle to help this happen. And so, you know, all of the gear for those first few years being, of course, imported, but then later their own switches that Huawei was selling domestically. Who were they selling it to? They were selling it to the government. They were selling it to cities. They were selling its towns. They were selling it back to the military itself. And the government was using it to set up a civil and military communications networks. Oh, that's interesting.

21:16Because of that, the government obviously had a big interest in what Huawei was doing and the products that it was providing, so much so that it started giving loans to the company to help them finance these projects that they were, these contracts that they were awarding to them. Somewhere along the way, the ownership structure of the company changed. So if you remember, Ren started the company with five co-founders. That is no longer the ownership structure of the company today. Today, The Huawei operating company is 100% owned by a holding company. Here we go. And who owns the holding company? Well, 1% of the holding company is owned by Ranjangfei. 99% of the holding company is owned by another entity that is a trade union committee. What is the trade union committee? Most directly, it represents the

22:08Union employees who work at the company and economically it does. It's effectively a profit sharing structure for employees working at the company. Again, this is China and China is a communist country and trade unions who do trade unions ultimately report up to and should there be any liquidation of Huawei where legally do the assets of the company go. They don't get distributed down out to the members of the trade union within the company.

22:37it gets distributed up and the trade union is ultimately rolls up to being part of the Chinese Communist Party which is of course the government. So this trade union has economic interest in the company but not sort of control over the company. If you if you own a lot of the sort of it's not equity but the I believe the phrase is restricted phantom shares in the union.

23:04Do you actually have any say over the governance of the company? No, you do not. And this is where it gets complicated. So as you say, economically, if you are an employee of Huawei and you participate in the trade union, which all at least Chinese employees of Huawei do, then yes, you do have an economic interest in the profits of the company. But yes, the governance and the control, and again, should there be a liquidation of the company does not come back to you.

23:33it goes ultimately up to the party. And an interesting other thing to note here, I mentioned the restricted phantom shares, which if you hold direct shares in a US company, you know, that should already feel a little bit different to you. A major way in which it's different is if you are no longer employed by the company, you don't have the right to own those restricted phantom shares. They are immediately purchased backed by the company. So you cannot sort of be an outsider who has, we already talked about no control, but now you can't even have economics as an outsider.

24:03So what does all this mean? You can start to see in a competitive global market such as the market for telecom networking gear. You all of a sudden now have this actor in Huawei who doesn't quite have the same economic incentives as other free market actors. They are a large portion of their projects are for domestic government uses. That government is directly funding the company via loans from state banks, state banks, and state-owned enterprise banks. And they also have a, if not economic, a governing seat at the table, shall we say, at Huawei. Now there's not anything, and you compare that to, you know, a international company, which is

24:50purely operating based on supply and demand and pricing power versus over both their suppliers and their customers in a normal market, and that's quite different. Now there's not necessarily anything.

25:02unique or necessarily wrong about this. China and other countries, indeed, even Western countries, have state-owned enterprises, companies like Airbus, are state-owned enterprises. What's interesting is Huawei isn't officially a state-owned enterprise, and it competes in an international market. Listeners, you might think, wow, Ben and David are really harping on this.

25:23they must feel it's important. Well Huawei feels it's important too because if you look at the 2018 annual report on the very first page before they even get into sort of like outlooks for the company and sort of the company's ethos, of course they have who is Huawei and the very second question is who owns Huawei and the answer is of course that they are a private company wholly owned by its employees.

25:46And that says, if I were to quote this, this scheme is limited to employees. No government agency or outside organization holds shares in Huawei. Now that's in the first five or six sentences of this entire multi hundred page document. Of course, that was not highlighted in the way that it is now before all of the events of the past six months started. Whatever the reasons, certainly.

26:11There's no arguing that Huawei at this time was an amazing growth story. Their products were good, at least as good if not better than the competition internationally in these markets that they were entering, and they were certainly cheaper. So you can start to see why, you know, first in...

26:28developing and redeveloping countries like Africa and Russia. Their networking gear products were much more attractive than those from competitors like say, Ericsson or Nortel in Canada. But then they keep, they keep innovating and they keep investing heavily in R&D, such as the point that as the years go by and wireless becomes a more and more important industry globally and a more technology driven industry, Huawei becomes one of the very top players internationally by 2002 they were doing over 500 million in revenue internationally annually and by 2005 they passed the revenue, international revenue, passed domestic revenue to be the majority of the company. Pretty impressive. Around the same time in the mid-2000s, you know, this is going to be a recurring theme here. Ren and Huawei's ambition is always growing larger. They've come to be one of the few dominant players in

27:26international networking gear for the back end for carriers they say maybe we need to think about getting into the other side of the business in telecoms and wireless as well and not just make gear for carriers but also make handsets.

27:41for consumers. And so in 2003, they released their first handset, and then in 2005, which is pretty early for the time, they shipped one of the first 3G phones available in the world. And then again, in 2009, at Mobile World Congress, they launched one of the first Android phones available.

28:01yeah very early to this stuff and that's that's kind of a crazy idea I mean if you think about of course there were others that manufactured the the sort of cell tower side equipment that also made the the handsets imagine that today I mean imagine that going the other way like Apple making the telecom equipment that goes on on the towers I mean I guess the strongest other example someone that did that was when Ericsson partnered with with Sony to produce that my dad actually had this phone is like a little candy bar and they were actually Erickson who's also a very large telecom equipment manufacturer was sort of in this business of having consumer branded phones for for a while and they they did pretty well but you know that was before the the smartphone era that we know today yeah and so what's interesting Huawei I think saw the opportunity in having both sides of this business that

28:55because they were driving a lot of the innovation on standards and capabilities on the backend side by having handsets on the On the front-hand side they could be playing off one another and keep introducing handsets that were early to taking advantage of all the new sets of the carriers were offering and so that's why you see them being you know being relatively early to to 3g being relatively early then to 4g and relatively early to you know the whole smartphone revolution and embracing android you know i didn't have this in the notes at all but why Why weren't they China mobile? Like why wouldn't you also find a way to be the carrier and really on the whole stack? So you didn't have this thing where it's like, like right now we're in this strange chicken of the egg game in the US where the carriers have to roll out 5G in order for the phone manufacturers to sell a high number of 5G phones and consumers are sort of sitting here waiting for both of those things to happen.

29:55at enough scale that it's useful. And so of course there's 5G phones come out but you only have them in certain cities and it's mostly bad. And so you have these three players where the handset manufacturers are waiting on the carriers to roll out the cell towers that are made by the Ericsons and the Huawei's the world. Like it really does feel like there's this sort of middle man missing in Huawei's business model where they really could own the whole stack.

30:23It's a good question. I didn't think about it, but I think I think it must be because China Mobile is a state-owned enterprise, I believe. Must be. Yeah, they probably couldn't get in that business. So they probably couldn't compete there. In the absence of that, you know, I think this is one of the things that's really so interesting about Huawei is obviously there is all of the political overtones to all of this, but their business strategy is really brilliant.

30:46participating heavily in both sides here as we were saying you know they're able to drive a lot of this to benefit of both the tick and the talk of innovation here and have as much inside information as you possibly could have on what's the best way to use this new technology rolling out yeah had they again been in a different market that's a really interesting question of like could they also have been a carrier they couldn't in China because ten of mobile was a state of enterprise they couldn't internationally because They're selling to the carriers and international and what are they going to go do? Set up carriers in all of these different countries. I mean, I guess they could have tried to acquire a vote of phone or some similar player along the way, but that probably would have invited a lot of political, a lot more political speculation that they managed to avoid. I'm sure this is something they thought of. So by 2010.

31:36Total revenue of the company has equipped $20 billion. They're almost $22 billion and net profit is almost $3 billion. By 2012, they overtake Ericsson, who he were mentioning been as the largest telecom equipment manufacturer in the entire world. And then last year, finally in 2018, as he said at the top of the show, they surpass Apple in handset shipments. So they're still smaller than Samsung. But Huawei is the second largest handset manufacturer in the entire world. People love their phones, love the cameras on them, love the technology. They shipped over 200 million handsets globally last year, which is

32:13an astounding number. I would say on the handset side of the business, Huawei is certainly at parity with other manufacturers out there. On the infrastructure side, Huawei is ahead of the field. When it comes to 5G, even though 5G networks aren't really rolled out.

32:34to the public anywhere yet. You know, consensus in the industry is that the quality of the technology of the gear that Huawei is producing is two to three years ahead of any of the competition out there in the market in terms of 5G.

32:48David, I'm not going to let you fully say that the Huawei phones are sort of at parity with everyone in the market. I was going to save this for a playbook later. But like, come on, there's, there's blatant ripoff after blatant ripoff of sort of Apple UI. And they're, they're not only, but like not only blatant ripoffs like every, this is a subjective comment, but it is a copy that is slightly worse in many, many facets every time they do it.

33:17I love it. If Steve jows were alive today, he would be railing against Huawei, not Samsung. But certainly people like the phones. And so much so that last year in 2018, they surpassed $100 billion in total revenue across their all their divisions. Half of that, 52 billion of which was in handsets and net profit for the company was almost $10 billion. So things are going Well, but then as you alluded to at the top of the show in December of 2018, a faithful event happens, which is that the CFO of Huawei, Mengwan Zhou, who is also the daughter of Ren Zengfei, it turns out, which blew my mind when I somehow missed that when all this news came out and doing the research for this episode. I was like, wait, Huawei's CFO is his daughter.

34:13Yes. And she has a different last name because she's his daughter by his first marriage. Her parents got divorced and she ended up taking her mother's family name, Meng, after the divorce. But yeah, she's his daughter. She was on an international business trip on route to Mexico City from Shenzhen and had a stopover in Vancouver, Canada.

34:39and after getting off the plane and attempting to go through customs was detained by Canadian border patrol, ultimately arrested and it turns out that the US had issued a extradition request for her and asked Canada to apprehend her and extradite her to the US to stand trial for allegations that Huawei had been reselling US technology equipment to Iran through a shell company that she had helped set up, which would of course violate sanctions. Now, this is interesting. It wouldn't necessarily violate Chinese law, but because so many of the components of the products that Huawei sells are made by US manufacturers, they by selling

35:29Huawei products and systems of Huawei products to band countries like Iran they would be violating US trade law by doing so because so many US components were part of it. Not only is it a you know absolute bombshell of a piece of news and a thing to do but it's not completely clear cut.

35:51that there's a case here. At some point this will go to trial and we will sort of see what the courts decide. I believe the current state is that she's on house arrest in Vancouver awaiting extradition of the US for trial. She has not been extradited to the US yet. She is still in Canada. Canada has not released her to the US. But it really makes question, you know, as we were talking about the Iran sanctions, you know, that is the charge.

36:20I don't think anybody really believes that that is what this is truly about. It's about the US and many other countries feeling threatened here that telecommunications infrastructure has become such an important part of any society. And Huawei is clearly the leader in 5G rollout. And what would it mean if Chinese company with strong ties to the state is now responsible for the majority of the backbone of the internet in countries around the world.

36:59Yeah, and I'll say on top of just this notion of wow, can this be owned by a foreign power? There have been several different research firms and different news stories that have come out sort of alleging that people have found security vulnerabilities in Huawei products that of course Huawei the company says is completely false and the security is of the utmost importance and not only are they not doing anything intentionally, but these are complete falsehoods, and the company is one of the most secure companies on the planet, and this is ridiculous that they're being accused of such things. And so you have this stalemate where the company says there's absolutely nothing wrong, and yet different journalists and different security researchers keep saying, hey, there are things to be concerned about here. Yeah. And what's interesting is it is, at least to me, as I was doing the research.

37:55It's not entirely clear that there is something wrong right now. It's more the potential that something could go wrong that people are worried about here. And of course, very shortly after the arrest of Mengwan Zhou, of course in the beginning of 2019, President Trump begins his trade war with China in earnest. And that has fall out for many companies, but Huawei kind of chief among them.

38:22So on May 16th of this year in 2019, the US goes so far as they put Huawei on what's called the entity list, which freezes all US companies from doing any type of business with Huawei without special permits. So what does that mean? We already alluded to the fact that, you know, if you think about a Huawei handset.

38:41and the same applies to Huawei Networking Gear. On the back end, the number of chips that are part of that and components that are made by US companies from Qualcomm to Broadcom to, you know, what have you is quite large. I mean, it's 50% or more of the total manufactured product. No component, at least on the smartphone on the handsets side of the business, is more important, of course, than the operating system.

39:09which is Android, which is sold by Google, which is one that sold, but is made by Google. which is of course a US company. And on top of that, David, even one more thing is ARM. And we discussed this being a British company that started out of Cambridge. I mean, go back and listen to the ARM episode. If you want details on that, that of course is owned by a Japanese company soft bank. Now, believes that they have significant US based IP as a part of ARM. And so they have also, even though they're over in the UK, they have also stopped licensing chips with the ARM instruction set architecture, which is basically all mobile chips to Huawei. So not just mobile chips, but but chips of all types in all use cases, including back in infrastructure. Oh, so that's that's all the impact on what can't be sold to Huawei from the US as an ingredients in the product. One more super interesting wrinkle here back to Android for a minute is

40:13There's commercial Android through Google. Obviously, you can understand how that would be prohibited from being distributed to Huawei because of the being played Huawei being placed on the entity list. You might say, well, of course, there's also the Android open source project. Android is an open source operating system and many of the flavors, well, really all of the flavors of Android.

40:35that are on handsets in China are not Google Android. It's open source Android because of course Google does not breed its services in China as we've talked about on other episodes. What's really interesting here is that because is that open source software right it really makes question is that open source software now legally it's a little bit of gray area but experts believe that because Google is the primary maintainer of the Android open source project and Google is a US corporation and entity, that actually makes even the Android open source project subject to this entity list ban by the United States. And even the core open source version of Android could potentially be off limits to Huawei from now on. It's wild. That's totally wild. No, of course, Huawei didn't have their head in the sand for the last 10 years or so thinking that like this was would never happen. They have been preparing

41:33contingencies, if this were to happen, and they've been working on their own operating system internally since 2012. But this is super interesting, like even if it were really great, if you could build your own operating system today, how far would that get you? Because you wouldn't have access to all the third party applications that are available on Android and iOS. So they could release their own, their own OS, but they wouldn't have the whole ecosystem of third party developers from, you know, Tencent and wechat on down that would participate in it So Google has actually appealed this to the government and said look we should be able to do this It's actually better for US national security if they are using Android because otherwise if they switch to a fork and start you know working on a completely different system that we no longer

42:22You know maintain in any way shape or form. You know, we actually have a lot less control and we actually the it could be that They fork something that has the security exploit and this is Google's argument here that Then gets sold in the US and then suddenly there's a bunch of Android phones in the US that have a security vulnerability that Google has no ability to fix and so you know Google's argument to the US government and of course, this is all in flight right now is Can we please keep Licensing Android Huawei. It's really important for all of us here. And it's fascinating to watch this game. And what we're really seeing here is if you think about this geopolitically, what the US government is basically doing in this chess game is daring China. They're saying, OK, you want to make a smartphone? Well, you can't use our operating system. And of course,

43:15If you make your own you don't have access to our apps but sure maybe you'll figure that out. You actually can't use the instructions and architecture for the chips that all the phones use so go make your own chips and instructions at architecture for those chips and oh yeah you can't use any of the sort of.

43:35like telecommunications chips either so you're gonna need to really do all of that on your own and you end up basically in this world if this fully gets played out where there's two completely different technology stacks one for the China world and one for everywhere else and it seems to be like the US government daring China to do that and daring Huawei to be the ones that that sort of figure out how to rebuild the phone computing stack.

44:03Obviously, this has not been a traditional acquired episode, but we thought it was so important to do this because knowing now all this history and what the current state of play is here between Huawei and Google and the US and China, and you start to think about that future. That's a really weird and not good future where they're right now.

44:30Basically, all of the standards. Of course, there are differences. Google services don't work in China. They do here. We chat services work much better in China than they do. We chat is crippled outside of China. But basically, we're all on pretty much the same internet. This is a future where both sides, the infrastructure back inside and the operating system front-end side for consumers, really diverges.

44:59I don't know what that means. One thing that we haven't talked about is the other side of the bidirectional exchange here. So you'll notice if you go, like we're talking about Huawei here, who makes these smartphones that are theoretically the second most sold in the world, plenty of your friends, or maybe you have a Samsung Galaxy. I bet very few people you know have Huawei phone if you're here in the US. Well, it depends on where you live. If you're in the US, but if you're in Europe, I bet you may have a Huawei phone. Totally.

45:27So one thing to observe from that is, you know, let's walk through a little bit more of a timeline. So in December, of course, we had this happen with the CFO of Huawei being detained and arrested. Then in January, AT&T was...

45:42Very close days away from from executing their deal with Huawei to distribute Huawei phones that on their network in the US and it would be available when you go to an AT&T store and at the very last minute They dropped that they blew up the deal and I'm not sure this was reported that it was because of pressure from US officials who distrust Chinese companies I'm not sure if that is a fact or sort of just something that that is sort of alleged but holy crap this is some very serious effort to limit the number of Huawei devices in the US, and they've really done it. If you look around, there's not a lot of Huawei phones. There's not a lot of Huawei tablets or laptops that are distributed in the US. And so to the extent that the US government was concerned about security on these devices, and they wanted to limit the distribution, they've really done that. But now the question is, you know, and this is back to really the troubling implications of separate internet.

46:39Yes, they've limited that in the US, but Huawei is incredibly popular in the rest of the world, you know, outside of the US and China. And that's everything from Europe to Africa to the Middle East to the rest of Asia to Australia. It's the number two global asset manufacturer. Yep. I will say too, the other thing that they limited in the US is all of these telecoms that are, you know, Verizon, AT&T, they're rolling out 5G networks are not doing it with Huawei equipment.

47:06So it's not just the handset side, but it is the infrastructure side. Yeah. So the last couple pieces in the chain of events here of history and facts is as many people know at the end of the G20 summit this year in June 29th, Trump and Xi Jinping announced that they intend to resume trade negotiations and Trump implied that as part of that, he might ease the restrictions on Huawei.

47:32and we back down from the edge here. But just yesterday on July 16, a bipartisan bill was introduced in the Senate. Imagine that a bipartisan bill in the Senate at all these days that would prevent the executive branch from unilaterally lifting those restrictions on Huawei. That's how critical Congress believes these restrictions are. So they want to keep the restrictions in place even if Trump wants to remove them.

48:01Wow, I did not see that. That is pretty intense. That's pretty, pretty crazy. So here we are. So one of the interesting things I think to discuss, and this kind of falls into the category of what would have happened otherwise, is we've talked on the show about other Chinese companies. We've talked about Tencent. We've talked about Xiaomi, a hands-on manufacturer. We've talked about Alibaba.

48:24Why is Huawei being treated so differently from these other companies? And I think a big piece of it is just the ownership and the structure of the companies. Like, what's interesting is, you know, the Tencent Alibaba, Xiaomi, Baidu, these are publicly traded companies that have a diverse international investor and ownership base. That is clearly not the case with Huawei. Yeah, Huawei, a company that did $108 billion in revenue last year and is still, quote unquote, privately owned by employees.

48:53Think about that in the US, the scale of that revenue, you're a public company, and of course there's exceptions. There are certainly private companies in the US and elsewhere that are very large, that are privately held, but the difference is they're privately held by individual shareholders. They're not held by a union that reports to essentially a government. Lots of concern among the United States government about this company.

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51:01So if you're trying to turn AI ambition into real business outcomes and make it work safely, securely at scale, go check out servicenow.com slash acquired and tell them that Ben and David sent you. Let's recap a little bit just so that we understand where they are as a business today. So they've got these three business lines, the telecom carrier networks business, which we were talking about that makes it all the telephone poll equipment, the devices business that with with smartphones, that's the second largest buy units in the world. And then they've got this enterprise business that provides equipment software and services to enterprise customers and government institutions. So this is a solutions or sort of a services business. If you look at what each of these businesses are doing, it's pretty interesting. So the business as a whole

51:47Group 21% last year. So they went from 93 billion in sales to 108 and a half billion. If you look at and sort of zoom in on that, what's going on there, the consumer business, which I think is their handset business, grew by 45%. So at the scale they're operating, that business unit grew at, you know, 45%. The carrier business actually shrunk by 1% last year.

52:13which is pretty interesting. I'm wondering if that's sort of people were refusing to buy the Huawei 5G equipment before this whole sort of consumer goods thing started to really shake out. But, you know, if you look at 26% growth and one of your enormous businesses shrunk at 1%, well, that, you know, they clearly made that up in the consumer business. The enterprise business also shrunk, but it's sort of less important to them than those other two. Yeah. My understanding is the enterprise business as you're saying, basically, implementations and solutions business for the carrier networking equipment. Yep. Exactly. 52% of revenue is from China itself. So that's shifted back and is China is more dominant for the company now from a purchasing perspective. If you read their annual report, they make a lot of noise about 5G. That this is something the company is really beating the drum on. But if you look at the revenue line, smartphone shipments are really the primary growth driver of the company. So sort of interesting to see a sort of

53:10narrative and numbers mismatch there. Well, do you want to move into playbook, David? And you know, not that we're not already here, but feels like we've laid all the facts on the table. Yeah. Yeah. So from a playbook perspective, aside from all the political questions surrounding Huawei, it's a really incredible example of seeing a long-term trend that is going to happen and capitalizing on it and capitalizing on it with really stellar strategy, the trend and trends that they capture were, you know, one, bringing China online, period, you know, building up telecommunications networks within China, you know, first is fixed line telephone, but of course that then bled into wireless and then the internet, but also capturing that internationally.

53:59and better than any of their competitors realizing this symbiotic relationship between the back end and the front end. As you said, Erickson and Nortel and other back end equipment providers, you know, made half-hearted attempts at hand sets over the years, but nobody has really been able to take the roadmap of what was going to be coming on the infrastructure side and translate that into compelling consumer devices and compelling consumer devices available relatively early versus competitors in the market as Huawei did. It's really well executed.

54:36There's a couple that I had on my list. The first is just an observation. The second is a geopolitical comment, which we should probably say we're pretty unqualified to do geopolitical analysis here and much like drifting into the airline industry for a little bit with the Alaska Airlines episode. Here, we are drifting into geopolitics away from our tech and business analysis just a bit because I think it's obviously incredibly important to this company in this story.

55:02playbook that they ran of how they grew in their first 10 years is really something that could only be done in China. If you thought, hey, I'm going to start a company in the US. I mean, I'm pretty US-centric in this show because it's what we know. But if you were living in Ohio and you said, hey, I'm going to start a business and over the next 10 years, I'm going to start by importing things.

55:28and then I'm going to slowly start making my own, and then I'm going to emerge as the dominant creator of that thing when I make my own. There are certain things that you wouldn't get to do, such as be really the only importer of something for an extended period of time, and then undercut the price by two thirds in order to really get yours at the deepest distribution. That's the... There actually is one thing we...

55:53glossed over a little bit in history and facts, which Huawei was not the only company that was benefiting from state support in doing this throughout these decades. There is another company called ZTE, which is a Chinese telecoms company. It's a direct competitor Huawei on both sides of the market, the backend and the hands that side. It's smaller and not as successful as Huawei, but the government was also supporting that company as well. Fair point. So there was some competition, but it was limited.

56:22Let me generalize my comment then and say that a lot of the lessons that could be learned and extrapolated from this company are not ones that would sort of universally apply the way that we think about a lot of our business model frameworks. The second sort of like geopolitical observation that I want to make is it's kind of unbelievable that to use the title of a book the earth becoming flatter and the world becoming more globalized that We are moving into an era where there could be two technology stacks. There's already kind of two internet. Like, if you think about the, there's sort of an hourglass shape here where for thousands and thousands of years, the East and the West developed differently. And it's kind of incredible that two completely different language systems emerged. I mean, the sort of Latin character set and Germanic languages and romance languages are all sort of super similar and use a similar character set or read a certain way or written a certain way.

57:16Eastern languages are, they influence each other, but they definitely don't borrow from this sort of western character set and western way of writing things down and communicating. It was a long time until, you know, the 18th, 19th, 20th centuries where those two worlds really met and then did business and, you know, started to really mesh and the world became flatter and more globalized. And here we are, like, 2019, and there's little cracks where it's starting to drift apart again, and it's just not a thing that I would have predicted. Yeah, me neither. And it's so weird, and again, part of why we're doing this episode, weird and a little scary. I mean...

57:58To me, it's wonderful. It's awesome that, like, here for us and acquired, like, are some of our most popular episodes, our Tencent, our Alibaba, these amazing stories of globalization, of wealth creation, of education, and really not just in China but across borders, you know, the ability for US investors and investors all over the world to be able to invest into those companies.

58:23at a corporate level of like like Yahoo, uh, and like Naspers, uh, Yahoo in in Alibaba, and Naspers in Tencent, uh, and then of course individual shareholders on the public markets. But then here you have this like, weird, Other story that is now taking center stage, you know, I really hope this becomes a blip and we go back to the incredible trajectory that this other narrative had been on and with recent IPOs, of course from China, Pindu Oduo and Maytwanda, I'm king and so many other great companies. It's really unodity. Well, listeners, you know this next section is usually grading, but since there's never been a transaction with this company, we have nothing to grade.

59:02I suppose maybe in the initial structure of setting up that 99% and 1% ownership, there's something there, but, you know, no party has ever taken control and watched value either, appreciate or depreciate after that. And so, what do we do here? Well, Dave and I were chatting before the episode and we thought what might make sense is just kind of to speculate on the future of the company and sort of think about which way things could go here and...

59:25If you're purely sort of an economic investor and thinking about the company, like, how would you sort of go about evaluating it at this point? Not that you could be, but just for fun. The downside is certainly down, but and these are some of the things that that Ren has been talking about in the interviews he's been given. It's not terrible. Like Huawei's if things go you know, South Internationalite for them, they're still very well positioned domestically in terms of 5G rollout. I mean, they do have the best integrated 5G technology in the market. And they of course have a tight relationship with the Chinese government. It's very plausible to believe that Huawei is going to be a big if not the sole beneficiary of 5G rollout in China and in China's allies. I literally can't imagine a world where that doesn't happen.

1:00:21Now what's interesting internationally and I think this gets back to why is Huawei being treated so differently than these other great Chinese companies is If this were happening with, say, Alibaba or Tencent, they would have a very, very powerful deterrent from any sort of less than malicious behavior or anything smelling like it internationally because they have the profit incentive. They would lose huge amounts of their business internationally if other countries stopped using their products. But for Huawei, because of the ownership structure and the incentives that they have, that's not as big a problem for them.

1:00:59That's pretty interesting, I think, about, yeah, that capital structure. It's kind of like in early stage startups, and we've talked about this a little bit on the LP show, David, but that governance is a blessing in some ways, where it can actually be to your advantage because then if their capital structure was such that they did have a bunch of shareholders who could...

1:01:19Of course, not only have the economic upside of the company being able to address a larger market and therefore the company naturally steering that way, but also a board who would sort of vote and say, it's important to us because we need to maximize the per share value of our ownership and every common shareholder's ownership. They could actually steer the company to do that. That is not the case here. The way that I sort of thought about grading is There's I have no concerns about the China market continuing the sort of massive massive appetite to buy the Huawei's great consumer devices But they seem to be having a rough time selling their telecom or consumer equipment into Europe or North America. And so, you know, we're this a company you could economically participate in. I would sort of want to evaluate the prospects of being able to do either one of those things sell the telecom or consumer equipment abroad. And I guess I shouldn't say abroad, but in the US specifically and the US's allies. And I also would

1:02:17want to really dig into how expensive is it going to be for us to write a new instruction set architecture build new chips write a new operating system and build that new developer ecosystem that's a new stack so yeah totally great all right carve outs well on that it shouldn't rush us here like should we take a deep breath should we say oh my god you like yeah this is this is quite the quite the different acquired episode Yeah, quite the different acquired episode. Well, yeah, thanks for being with us listeners. As the show has grown, it's been great to get feedback on every episode. So I think if you, if you do know more than we do here, um, would love to hear it and happy to do any, uh, any follow up or, or maybe do a follow up as a, as an LP episode or something like that. But would love your, uh, your takes on this. And if you know anything we don't, would love to hear that too. Yeah. Car Rats. Car Rats.

1:03:11I just got back from summer vacation in Europe at a great time. We were in Morocco and Portugal. Portugal is a great, great country. Highly recommend it if you want a beautiful, relaxing travel with diversity of all types there. That was really wonderful. But while I was on vacation, I read the re-read the Dune series by Frank Herbert. Just excellent.

1:03:38classic classic classic science fiction series apt for this episode because you know really an analogy of politics and political systems and long-term implications of different versions of that but so good and super cool also like I didn't realize the first time when I read Dune many years ago but reading it now like the influence on Star Wars is like So clear. So clear, especially the first one, Dune. I'm very, very clearly. You can see where George Lucas was influenced by it. That's cool. I have to confess I did not make it through Dune. I may, uh, it's like, give another shot. My carve out is the Showtime original series, Billions. David, have you watched this? I have not, but so many people have recommended it.

1:04:27I am after this episode going to watch the final episode of season four after just binging all four seasons over the last month or so. It is absolutely spectacular. And if you like this show and you like good drama, it is like an absolute treat to watch every episode. So the show is created by Brian Coppelman, David Levian, and Andrew Ross Sorkin.

1:04:50who some of you may recognize as a New York Times writer. Brian Coppelman, who sort of is the lead on it, is also the guy behind the movie, Rounders, which some of you may remember with Matt Damon. Yep. Yeah. Classic. Great story.

1:05:05So billions getting into the plot is is loosely based on pre-barara who was the US District Attorney for the Southern District of New York and his massive legal battle with Steve Cohen who is a of course a big hedge fund manager and it's played. Yep, yep, and the roles are so Paul Giamatti plays the attorney for the Southern District and Damian Lewis plays Bobby Axelrod, who is running XCAP, which is the sort of top, top fictional hedge fund on the street. And the drama that ensues and the cat and mouse game and the whole dance between these two characters and every other character involved is like a total treat to watch. And frankly, I want to hurry up and finish this episode so I can go and watch the last episode. All right. Well, on that note, all right listeners.

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1:07:20David and I are gonna record another one of those this week and you should see that popping into your podcast player. If you are already an LP or if you're trialing a new subscription you will you will see it as well. So with that we will see you next time. See you next time.