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Mon, 22 Jul 2019 15:04

For our first episode of Season 5, Acquired returns to Shenzhen to cover another Chinese technology giant, this one slightly... different from our past subjects: Huawei. From a backwater importer of PBX switches to the world’s second largest handset manufacturer and near-undisputed leader in 5G infrastructure technology, Huawei’s ascent over the past 30 years has been nothing short of spectacular, equaled only by the spectacular fireworks of recent events surrounding the company. What’s the story behind this global telecom giant, and what does its future portend for global tech and US - China relations? We dive in.


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Interest 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 me 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 And I'm David Rosenthal and I am a general partner at Wave Capital and 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 it 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. Oh, 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 gonna be fun. This is a little bit of an experiment for us here at acquired This is obviously not an acquisition nor an IPO and in fact there is a 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 you we 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 Our presenting sponsor for this episode is not a sponsor but another Podcast that we love and want to recommend called the founders podcast We have seen dozens of tweets that say something like my favorite podcast is acquired and founders So we knew there's a natural fit. We know the host of founders well David Senra. Hi David. Hey, Ben. Hey David. Thank you for joining us Thank you for having me. I like how they group us together And then they say it's like the best curriculum for founders and executives. It really is we use your show for research a lot I listen to your episode of the story of akyo marita before we did our Sony episodes this incredible primer You know, he's actually a good example of why people listen to founders into acquired because all of history's greatest entrepreneurs and Vesteres they had deep historical knowledge about the work that came before them So like the founder of Sony who did he influence Steve Jobs talked about him over and over again if you do the research But I think this is one of the reasons why people love both of our shows and they're such good Compliments is on acquired we focus on company histories You tell the histories of the individual people you're the people version of acquired and where the company version of founders Listeners the other fun thing to note is David will hit a topic from a bunch of different angles So I just listened to an episode on Edwin land from a biography that David did David it was the third fourth time you've done Polaroid I've read five biographies of Edwin land and I think I've made eight episodes of them because in my opinion the greatest Much puner to ever do it my favorite entrepreneur personally is Steve Jobs and if you go back and listen to like a 20 year old Steve Jobs He's talking about Edwin lands my hero So the reason I did that is because I want to find out like I have my heroes who were their heroes and the beauty of this is The people may die, but the ideas never do and so Edwin land had passed away way before The apex of Apple, but Steve was still able to use those ideas and now he's gone and we can use those ideas And so I think what requires doing what a founder trying to do as well is find the best ideas in history and push them down the generations Make sure they're not lost history. I love that Well listeners go check out the founders podcast after this episode you can search for it in any podcast player Lots of companies that David covers that we have yet to dive into here on acquired so for more indulgence on companies and founders go check it out All 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 to acquired Yeah, a little bit nervous 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 was a great time I was being born Shortly after that close to the importance 1984 yeah most important part of the episode but we just and We recall back to a lot of the same themes we talked about in our 10 cent episode if you remember that and that was both Shenzhen the city in China across the bay from Hong Kong and 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 you know 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 Deng has taken over leadership of the party and he has seen and lived through all the turmoil the cultural revolution and he believes that China needs to move forward and He he ceases 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 Let me get me talked about this on the 10th and episode and what he sees is China as the the system in China is being socialism In communism, but with Chinese characteristics and 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 Shenzhen as a special economic zone that is going to be the Testbed for this idea of keeping China as a communist political system, but reintroducing Capitalism and the market economy It'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 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 our the economy in this area is going to be different than that of the rest of our nation Yeah, yeah completely and Obviously the experiment was a success, but in attendance in 1982 at that national Congress that very national Congress was a 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 Zhang Fei Ren is better known today as the founder and CEO of Huawei, but back then he was a long way from those heights So who who is Ren? Well one he's a very witty individual He he's been a little bit of a 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 Suclusion is given many interviews to Western media and Eastern media Yeah, 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 Yeah, you know just to give you a little taste will will link to a few interviews with him The you can find on YouTube and other sites online But he was asked by Bloomberg and one of these interviews You know how he he feels about all the action that the US has taken against his company and in particular how it's gonna Impact the these bands the smartphone division and he says this is a quote We might miss our growth target, but we are still growing being able to grow in the toughest battle environment That just reflects how great we are That gives you a little flavor for for rent so who's rent he was born in the 1940s in rural southern China His father had actually been college educated Which was incredibly rare for that time and place both he rents father and his mother were school teachers and Ren ends up going 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 Ren signs up he joins the PLA as a 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 well enough at that and 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 National Congress and historic Congress where we're done to 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 Dangan and this vision and leader and he decides he needs to he 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 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 there's no mobile telephones There's no wireless industry. These are all fixed line Telephones and switches. Yeah PBX So the government is trying to find ways to import Telephones switches into the country and so Ren sees this and of course he had been part of the army and part of 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 years into his job He leaves in 1987 and he starts a firm along with five other co-founders to do just that import PBX 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 five thousand dollars at the time that's A debatable whether that it 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, you know starting a company and and becoming a entity that generates a profit and 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 You know you the thought of doing something illegal can can totally cross your mind and you can sort of still do it But this was one step further where you 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 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, Hua means China and way 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. Yeah, 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 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 a it's quite the vessel to be able to do whatever he wants within So the initial aim of the company of course as we said is to import these Telephones which is 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 and 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 gonna Do that and gonna do that on a 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 a pretty strong R&D and engineering group that grows Who 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 Shudog Where Nike started as the blue ribbon shoes and they were importing only two cat tigers and reselling those and you you'd go to your blue ribbon guy to get your own two cat 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 you know things from from the 80s Well, it's funny like Technology now is such a Intellectual property driven business. Yeah 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 you know 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 is they introduced their first product on their own the CNC08 digital telephone switch and they introduced 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 the 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 thereafter in 1996 They 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 and things really start to work right around the same time And this is the mid-90s Wireless is 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 This really starts to lay the groundwork for that You know when I was introducing the episode you know saying that they're the the largest telecom equipment manufacturer You know 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 you know they make 5G equipment now, but they've made basically every generation of You know equipment that goes on cell towers and is used in the backbone of cell phone technologies since the mid 90s So the question you might ask you to we've been telling this story of grand International scale ambition from the unlike list of places Be getting 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 the largest Wireless telecoms gear provider to countries completely outside of China and here I thought you were just gonna 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 Devastically 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 That's interesting because 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 one percent of the holding company is owned by Ren Zhangfei 99% of the holding company is owned by another entity that is a trade union committee Uh, what is the trade union committee Most directly it represents the union 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 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 It gets distributed up and the trade union is ultimately Rolls up to being a 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 Uh, it's not equity, but the I believe the phrase is restricted phantom shares in the union Do you actually have any say over the governance of the company? No, you do not um, and it's 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 Um, then yes, you do have an economic interest in the profits of the company Um, but yes the governance and the control and again should there be a liquidation of the company does not come back to you It 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 So 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 how 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 A state banks and state-owned enterprise banks and they also have a If not economic a governing um seat at the table, shall we say at Huawei And now there's not anything and you compare that to you know a a international company Which is purely operating based on supply and demand and pricing you know power versus Over both their suppliers and their customers in a normal market and that's quite different now There's not necessarily anything unique or necessarily wrong about this China and other countries Indeed even Western countries have state-owned enterprises, you know companies like Airbus Our 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 like They 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 and sort of the companies 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 And 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 There'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 are entering and they were certainly cheaper So you can start to see why you know first in developing and redeveloping countries like Africa and Russia They're 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 to 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 five hundred 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 gonna 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 International networking gear for the backend 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 for consumers and so in 2003 They released their first handset and then in 2005 which is pretty early for the time They ship one of the first three G phones available in the world and and then again in 2009 at mobile world congress they launched one of the first android phones available Yeah, 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 Erickson partnered with With Sony to produce that my dad actually had this phone is like a little Candy bar Yeah, 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 error that we know today Yeah, and so what's interesting Huawei I think saw the opportunity in having both sides of this business that because they were Driving a lot of the innovation on standards and capabilities on the back-end side by having handsets on the On the front-end side they could be playing off one another and keep introducing handsets that were Early to taking advantage of all the future 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 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 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 at 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 middleman Missing in Huawei's business model where they really could own the whole stack It's a good question. I didn't think about it, but I think I think it must be because China mobile is a Stino enterprise I believe Must-be yeah, they probably couldn't 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. It's really so interesting about Huawei's You know, obviously there is all of the political overtones to all this but their business strategy is really brilliant by Participating 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 China mobile was a state of enterprise They couldn't internationally because They're selling to the carriers and international and what are they gonna 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 and show this is something they thought of So by 2010 Total revenue of the company has equipped 20 billion dollars They're almost 22 billion dollars and net profit is almost 3 billion dollars By 2012 they overtake Eric said who you were mentioning then as the largest telecom equipment manufacturer in the entire world And then last year finally in 2018 as you 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 an astounding number. I would say on the handset side of the business Huawei is certainly at parity with other manufacturers out there be it Samsung or Apple or the like On the infrastructure side Huawei is ahead of the field You know when it comes to 5G even though 5G networks aren't really rolled out to 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 2 to 3 years ahead of any of the competition Out there in the market in terms of 5G David I'm not going to let you fully say that the Huawei phones are are sort of at parity with everyone in the market I was going to save this for playbook later, but like come on there's there's blatant ripoff after blatant ripoff of Of sort of Apple UI and their their bottom-up operating system And and not only but like not only blatant ripoffs like every This is a subjective comment, but it is a copy that is slightly worse on in many many facets every time they do it I love it if Steve jowls were alive today he would be railing against Huawei not Samsung But certainly people like the phones and so much so the 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 I fateful event happens which is that the CFO of Huawei Mengwan Joe who Is also the daughter of Ren Zhangfei it turns out which blew by mind when I somehow missed that when all this news came out And doing the research for this episode. I was like wait. Well always CFO is his daughter Yes And she has a different last name because um He she's his daughter by his first marriage Here the 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 a International business trip on route to Mexico City from Shenzhen and had a Stopover in Vancouver, Canada and And 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 extradate 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 Huawei products and systems of Huawei products to banned 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 that 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 for trials. So he has not but 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 but I 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 a Chinese, you know, a company with strong ties to the state Is now responsible for the majority of the backbone of the internet in countries around the world Yeah, 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 this complete falsehoods and the company is You know, it's 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 you know the company says there's absolutely nothing wrong and yet Different journalists and different security researchers keep keep saying hey, there are things to be concerned about here Yeah, and what's interesting is like it is at least to me as I was doing the research It's not entirely clear that there is something wrong right now. It's more the potential that something could go wrong Yeah, that people are worried about here and of course very shortly after the arrest of Mengwan Zhou uh, of course in the beginning of 2019 president trump begins his trade war with China in earnest Uh, and that has fallout for many companies, but Huawei kind of chief among them So on May 16th of this year in 2019 the US Gosephars they put Huawei on was 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 and the same applies to a 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 um is quite large. I mean it's 50% or more of the total manufactured product no Component at least on the smartphone on the handset side of the business is more important of course than the operating system Which is android which is sold by google which is a one-not-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 discuss this being a British company that you know started out of Cambridge Um you can go back and listen to the arm episode if you want details on that uh that of course is owned by a japanese company softbank now believes that they have significant US based IP as a part of arm and so they have also even though they're they're over in the UK They have also stopped licensing chips with the arm instructions at 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 Wrinkler here back to android for a minute is There'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 You know android is an open source operating system and many of the flavors well really all of the flavors of android That are on handsets in china are not google android It's open source android because of course google does not operate 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 begs question of 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 why on that's what totally well 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 contingencies 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 we chat on down That would participate in it So google has actually appealed this to the government and said look we should be able to 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 You 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 to Huawei? It's really important for all of us here and it's fascinating to watch this game and what we're 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 okay Um, you want to make a smartphone? Well, you can't use our operating system and of course if you make your own you don't have access to our apps But sure maybe you'll figure that out Um, you actually can't use the instructions at 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 like 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's 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 the phone computing stack Yeah, obviously this has not been a traditional acquired episode But we thought it was so important to do this because you know 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 like Weird and not good future, you know where they're you know right now Basically all of the standards of course there are you know There are differences like Google services don't work in China. They do here You know we chat services work much better in China than they do you know we chat is crippled outside of China But basically like we're all on like pretty much the same internet This is a future where like both sides the infrastructure back inside and the You know operating system front-end side for consumers really diverges and I 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 a Huawei phone if you're you're here in the US Well to them where you live if you're in the US. Yeah, yeah, but if you're in Europe I bet you may have a Huawei phone totally So 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 being detained and arrested Then in January AT&T was Very 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 we don't there's not a lot of Huawei phones There's not a lot of Huawei tablets or 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 Mm-hmm, but now the question is you know, and this is back to really the troubling implications of Separate internet's Yes, 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 hands-up manufacturer Yep, I will say to the other thing that they limited in the US is All of these telecoms that are there you know Verizon 18t. They're rolling out 5g networks Are not doing it with Huawei equipment Mm-hmm. So it's not just the hands-up side, but it is the infrastructure side. Yeah So the last um, 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 on 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 and you know kind of we back down from the edge here But just yesterday on July 16th a bipartisan bill was introduced in the Senate Imagine that a bipartisan bill in the Senate at all these days Um, 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 Wow, I did not see that that is pretty uh is pretty intense. That's pretty pretty crazy So here we are So one of the interesting things I think to discuss uh, and this kind of falls into the category of what would have happened otherwise is You know, we've talked on the show about other Chinese companies we've talked about Tencent We've talked about Xiaomi a hands-up manufacturer. We've talked about Alibaba Why is Huawei being treated so differently from these other companies? And I think a big piece of it is is just the ownership and the structure of the companies like what's interesting is you know The Tencent Alibaba Xiaomi buy to 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 dollars in revenue last year and is still quote-unquote privately owned by employees Yeah, like think think about that in the US the scale of that revenue That like you're a public company and of course there's exceptions like there are certainly private companies in the US and elsewhere That are very large that are privately held but but the difference is um, they're privately held by Individual shareholders. They're not held by a union that reports to essentially a government So lots of concern among uh among the United States government about this company 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 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 the business as a whole grew 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 that business unit grew at you know 45% the carrier business actually shrunk by 1% last year Which 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 to really shake out But you know if you look at 20% 6% growth and one of your enormous businesses shrunk at 1% Well that you know they clearly made that up in in the consumer business the the enterprise business also shrunk But it's sort of less important to them than the then those other two Yeah, my understanding is the enterprise business is as you're saying basically Implementation since solutions business for the carrier of networking equipment. Yep exactly 52% of revenue is from China itself So that's shifted back and is 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 this is something the company is really beating the drum on But if you look at the revenue line smart phone shipments are really the the primary growth driver of the company So sort of interesting to see a sort of narrative and numbers mismatch there Mm-hmm 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 gonna 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 blood into wireless and then the internet But also Capturing that internationally and and better than any of their competitors realizing this this symbiotic relationship between the back end and the front end as you said ericson and nor tell and other 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 You know relatively early Versus competitors in the market as Huawei did It's really well executed There's a couple that I had on my list the first Is just an observation in the second is a geopolitical comment Which we should probably say we're pretty unqualified to do geopolitical analysis here and and much like drifting into the airline Did his tree for a little bit with the the Alaska Airlines episode here? We are drifting into geopolitics away from our sort of tech and business analysis Just a bit because I think it's it's obviously Incredibly important to this company in this story This playbook 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 you know, hey, I'm going to To start a company in the US. I mean, I'm pretty US-centric in my in this show because like it's what we know But if you were say 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 And 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 you know two thirds in order to to really get yours at the deepest distribution And now it is important to note there actually is one thing we we glossed over a little bit in his trim 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-on side It's smaller and not as successful as Huawei, but the the government was also supporting that company as well Okay, fair point. So there was some competition, but it was limited Let 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 Conversely apply the way that we think about a lot of our business model frameworks. Yeah 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 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 And eastern languages are they influence each other, but they definitely don't Barrow from the sort of western character set and 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 to 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 to me. It's it's wonderful It's awesome that like here for us and acquired like are some of our most popular episodes are 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 at a corporate level of like Like Yahoo and like naspers Yahoo and in alibaba naspers in Tencent 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 Pinduadu and may twant to I'm geng and so many other great companies. It's really an oddity 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 I suppose maybe in the initials 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 appreciated or depreciate after that And so what do we do here? Well, David and I were chatting before the episode and we thought what might make sense is just kind of to to speculate on the future of the company And and sort of think about which way things could go here and if you're purely sort of an economic investor and 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 this these are some of the things that that Ren was has been talking about in the interviews he's been given It's not terrible like Huawei's if things go you know south internationally for them They're still very well positioned domestically in terms of 5G roll. 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 Now, 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 That's pretty interesting. I think about yeah that capital structure It's kind of like in early stage startups and we 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 tier advantage because then if Uh, their capital structure was such that they did have a bunch of shareholders who could Um, of 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 shareholders ownership The they could actually steer the company to do that. That is not the case here Mm-hmm 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 the Huawei's great consumer devices Um, 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 we're this a company you could economically participate in I would sort of want to evaluate the prospects of 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 in in the US specifically and the US's allies and I also would Want to really dig into how so 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 and build that new developer ecosystem. That's a new stack So yeah totally agree All right carveouts Well On that it shouldn't rush us here like should we take a deep breath should we say oh my like yeah Yeah, this is this is quite the uh 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 routes Carvouts I just got back from Summary vacation in Europe had a great time. We were in Morocco and Portugal Portugal is a great great country highly recommend it if you want a beautiful relaxing uh travel with diversity of all types uh there That was really wonderful But while I was on vacation I read the uh reread the dune series by Frank Herbert Just excellent classic uh classic classic science fiction series apt for this episode because um you know really an analogy of politics and political systems and uh 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 uh 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 mean uh it's a quick I'm giving 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 I am after this episode going to watch the final episode of season four after just bingeing 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 Coppillmann, David Levian and Andrew Ross Sorkin Who some of you may recognize as a New York Times writer Brian Coppillmann 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 and Yeah, classic great story So 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 Um with Steve Cohen who's a of course a big hedge fund manager and it's played uh I see right Yep, yep, and the roles are so Paul Giamatti plays the attorney for the southern district and uh Damien Lewis plays Bobby Axelrod who is running x cap, 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 if you aren't a limited partner yet Subscribing gets you access to our bonus show where we dive deeper into the nitty-gritty of building companies and last week We covered due diligence and the work that typically gets done by a venture capitalist and uh entrepreneur in the diligence process to listen you can click the link in the show notes or go to slash acquired and all new listeners Get a seven-day free trial David and I are gonna record another one of those this week and you should see that popping into your 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