One of the hottest pieces of telecommunications equipment these days is the digital loop carrier (DLC), which allows telecom operators to extend digital subscriber services—including the triple play of voice, data and video—to consumers. And guess which company sells the most DLCs? Not Alcatel. Not Nortel Networks It's China's Huawei Technologies, according to market research firm In-Stat (a division of EB's parent company).

Huawei doesn't have the most technologically advanced DLCs on the market—Alcatel can probably claim that distinction, according to Henry Goldberg, an In-Stat analyst. Rather, Shenzhen-based Huawei sells low-cost, no-frills DLCs to the world's fastest-growing markets: the industrializing countries of Asia, Latin America and Eastern Europe. In fact, 90 percent of Huawei's DLC sales are in its home country, China. But the company is using that solid position in its booming home market to go on the attack around the world. Sales outside China went from close to zero in 2000 to $1.1 billion in 2003 and were expected to reach $2 billion in 2004. Total sales have grown by more than 40 percent for each of the last two years, even as the global telecom equipment market has shrunk and dragged Alcatel, among others, deep into the red (see "A Tough Market," below.)

Now, just as global equipment sales have started to recover, Huawei is turning up the heat. The company expects to double sales outside China in 2005 to $4 billion by moving into the United States and Europe, according to Richard Lee, Huawei's deputy director of corporate communications. It is stealing telecom customers from Lucent Technologies and Ericsson; through a joint venture with 3Com, it is striding into enterprise networking equipment, challenging Cisco Systems and Juniper Networks; and it is now working on next-generation mobile phone handsets, preparing to face Nokia and Motorola.

And Huawei is not the only telecom and networking equipment maker charging out of China. Huawei's chief domestic competitor, ZTE, doubled its international sales in 2003 to $610 million. FiberHome Technologies Group, a commercial arm of a Chinese national research center that makes optical fiber cables and gear, gained major contracts last year in India, Iran and Australia. And analysts say that the next Chinese company likely to branch out into the global market is Harbour Networks, founded by former Huawei employees to develop next-generation data networking equipment.

"Cisco will not just be a vendor, but a trusted business advisor as well."
—John Chambers, president and chief executive officer, Cisco Systems Inc.

"The established global leaders have every reason to be taking this as a very serious competitive threat," warns Joseph Ableson, vice president of emerging markets at research firm iSuppli. "These companies are already successful at home, and they have aggressive strategies for penetrating the global market."

Huawei is the undisputed the leader of this pack. And a look at how the multinationals are responding to Huawei's challenge gives insights into the strategic battles likely to shape the industry for the rest of the decade.

The Huawei threat comes not from low-cost manufacturing—which is now a given throughout the industry—but from low-cost engineering. Huawei has an R&D work force of more than 10,000 people, many of whom have master's or Ph.D. degrees and whose salaries are one third to one fifth those of their Silicon Valley counterparts. This engineering work force enables the company "to tailor-make innovative solutions for big customers that are looking to reduce their capital expenditures," says Johnson Hu, Huawei's vice president of marketing.

The employee-owned company was established in 1988 by Zhengfei Ren, a former army officer. Huawei became China's largest telecom and networking equipment maker by the mid-1990s and soon made plans to go global. The company got started supplying developing countries with technology good enough for local needs. In 2000 it made its first significant international sale to a Russian telecom carrier. That was quickly followed by sales to Advanced Info Service, Thailand's largest mobile phone carrier, and Brazil's fixed-line carrier Tele Norte Leste Participacoes. Most recently Huawei has won deals with a Dutch mobile operator, Telfort, and the second-largest Internet service provider in France, called Free.

Now it is moving upstream with more-sophisticated products. For example, Huawei is emerging as a leading player in third-generation (3G) mobile phone equipment, which brings broadband Internet access and videoconferencing to mobile phone handsets. The company is supplying 3G systems to carriers in Europe, Africa and the Middle East, even before China settles on a 3G standard. "It's remarkable what Huawei is doing in 3G equipment, because it has no home market in which to sharpen its teeth," says Mark Natkin, managing director of Marbridge Consulting, a Beijing-based telecom consulting firm.

And Huawei is starting to win 3G business from customers that previously relied on some of the stalwarts of the telecom business.

Telfort, for example, has been using Ericsson equipment for its GSM network. But when it came to buying equipment for a 3G Universal Mobile Telecommunications System (UMTS) to provide mobile broadband access to the Internet and services such as video telephony, Telfort picked Huawei. "We are very impressed by the innovative activities of Huawei," says Theo van der Wiel, director of networks and systems for Telfort, noting that the company chose Huawei for its technological expertise as well as its products' low cost.

"Carriers are more and more concerned about infrastructure cost, and Huawei is well positioned to play the low-cost role," says Marcus Sigurdsson, a telecom analyst with Gartner in Hong Kong, explaining Huawei's appeal. "We have opportunities in markets where companies are trying to reduce their capital expenditures," agrees Hu.

Asking what Huawei's U.S. and European rivals can do to fend off the Chinese "is like asking what American consumer electronics companies could do when faced with the onslaught of Japanese technology in the 1970s," says Zeus Kerravala, an analyst at the Yankee Group in Boston. "Some loss of business is inevitable. It's just cheaper to do engineering over there," he adds.

Thus, many multinationals are lowering their R&D costs by setting up operations in China, say analysts. "There's no question that foreign vendors are locating more and more R&D here," says Beijing-based consultant Natkin. Nortel now has more than 1,000 engineers working on research and development in China—about one fifth as many as at its R&D headquarters in Ottawa, according to the company. Lucent Technologies opened a 3G R&D center in Nanjing in September 2003 and announced plans to expand it last fall. Also last fall, Juniper Networks announced that it would soon open a research and development center in Beijing.

"The established global leaders have every reason to be taking this as a very serious competitive threat. These companies are already successful at home, and they have aggressive strategies for penetrating the global market."
—Joseph Ableson, vice president of emerging markets, iSuppli

At first many companies that set up R&D operations in China did so merely to keep in touch with the local market. But increasingly the Chinese centers play a key role in worldwide development efforts. Lucent's Nanjing center, for example, allows the company "to take advantage of the already significant contributions of researchers and engineers in China to support our customers globally," says Mary Chan, president of global wireless R&D for Lucent's Mobility Solutions Group.

Nokia has also recognized the need to tap into low-cost Chinese R&D. Within a couple of years, Nokia will have 40 percent of its worldwide handset R&D based in Beijing, and it is increasing its local infrastructure equipment development efforts as well, says Natkin.

Such moves by multinational handset vendors may be especially important in blunting Huawei's push into the 3G mobile phone handset market, which represents the company's first attempt to sell to consumers. Because U.S. and European consumers may not recognize the Huawei brand name, the company will concentrate on selling to mobile operators that will resell the handsets under their own name or will cobrand them with Huawei, says Lee. The operators usually offer customers a wide range of handsets from various vendors, but the top brands, such as Motorola and Nokia, command a premium. If that premium is too steep, consumers may opt for Huawei, says Natkin.

Huawei has a similar branding problem in the enterprise networking market. When U.S. and European companies buy switches, routers and phone systems that use voice over Internet protocol (VoIP), Huawei is not top-of-mind. What's more, Huawei has lacked the distribution connections to sell enterprise network equipment in the U.S. and Europe.

Huawei has tried to address these problems by working with 3Com, a U.S. networking company that's been struggling since the Internet bubble burst. In November 2003, the two companies launched a joint venture to develop and market enterprise networking equipment. 3Com put up $160 million in cash and contributed intellectual property, its business operations in China and Japan and several dozen managers. Huawei threw in its enterprise networking business, plus the majority of the joint venture's 2,000 employees. The joint venture's headquarters are in Hong Kong but it has new R&D and production facilities in Hangzhou, China. 3Com sells the Huawei-3Com products under its own brand throughout the world excepting China and Japan, where the joint venture sells its own and 3Com products. The venture started with 51 percent owned by Huawei, but 3Com has an option to acquire a majority share after two years.

On paper, the deal seems mutually beneficial. Huawei gets sales and support channels for its enterprise products in North America and Europe. 3Com gets to fill out its portfolio with high-performance products that the Yankee Group's Kerravala says sell for 20 percent to 30 percent less than what's currently available from competitors.

"It's remarkable what Huawei is doing in 3G equipment, because it has no home market in which to sharpen its teeth."
—Mark Natkin, managing director, Marbridge Consulting

According to Huawei's Hu, the joint venture had more than $300 million in sales its first year and turned a profit, although he won't say how much. And Huawei expects sales to double in its second year.

Things don't look so bright from the 3Com side, where the joint venture doesn't seem to be making much difference in its falling fortunes. 3Com's sales fell from a high of $5.2 billion in 1999 to $698 million in the year ending May 2004. 3Com's total sales turned down in the first half of the current fiscal year, after improving in the previous six months, and the company continues to lose money. (3Com did not respond to requests for an interview.) A recent Morgan Stanley report on 3Com calls revenue generated by the joint venture "disappointing." It goes on to say that 3Com should still benefit from the venture's products, particularly VoIP systems, and a general upturn in corporate IT spending. But "first mover advantage from low-cost Chinese R&D and manufacturing may be eroding."

If 3Com continues to stumble, it could be takeover bait. "I wouldn't be surprised if Huawei ended up buying 3Com or at least taking control of the joint venture," says Marbridge Consulting's Natkin. The idea is certainly not outrageous in the wake of Lenovo Group's purchase of IBM's PC business in December.

Other vendors stress that they'll counter the Huawei competition by staying on the leading edge of technology and by delivering red carpet service and support. That's how John Chambers, Cisco Systems' CEO, thinks he can stay ahead of the Chinese competition.

At an analyst conference in December, Chambers described his view of Cisco as the premier provider of network security. An expanding host of Internet-enabled devices, including next-generation mobile phones, represents a new wave of possible security threats to corporate networks, he said. Chambers thinks networks will have to be capable of responding to intrusions and viruses before human operators become aware of them. And security will be most effective and efficient if a common strategy extends throughout all of a corporation's wired and mobile networks. To make sure it is ahead of the competition in both technology and expertise, Cisco has over the last couple of years acquired 14 companies involved in network security. And as for service, Chambers intends to take Cisco from just selling networking equipment to helping customers figure out how to use new networking capabilities to boost productivity and the bottom line. "We will be not just a vendor but a trusted business advisor as well," he told the analysts.

The Yankee Group's Kerravala thinks Cisco has a good chance of making this work. Enhanced security features could help keep networking gear from becoming a commodity. Cisco's customers are willing to pay more for such features, but if the price gap gets too big, they may start asking for hard data. "Cisco will have to quantify how state-of-the-art service benefits customers," Kerravala says.

And Huawei and its Chinese peers will have a hard time matching Cisco's level of service, because they are still in the early phases of building their global service-and-support networks, says Gartner's Sigurdsson. And the bigger customers want to see evidence of those service capabilities "before they spend tens of millions of dollars on equipment," he notes.

Cisco may be taking the high road on service and support, but it is also not afraid to get down and dirty when it comes to protecting its technology. In January 2003, Cisco sued Huawei for allegedly copying software and infringing several patents. Huawei agreed to stop using the software involved, which affected only a few products, and the two companies negotiated a confidential settlement in July 2004.

But even as the details of that agreement were being finalized, a Huawei employee was allegedly caught poking around in the cabinet of a Fujitsu optical networking device after hours at the June 2004 Supercomm trade show in Chicago. Fujitsu is not pursuing any legal action, but the matter is still being investigated by the U.S. Federal Bureau of Investigation as possible industrial espionage. Huawei says it was all a misunderstanding involving an inexperienced employee on his first overseas trip.

Given how common patent disputes are, Kerravala says the incidents aren't likely to hurt Huawei in the long run. And given how much Huawei is investing in R&D, he wouldn't recommend picking intellectual property fights with the company as a strategy. He says that at one time, Japanese electronics firms were also viewed as intellectual property scofflaws. "But today nobody would think of accusing Sony of not doing its own R&D," he says.

Meanwhile, Huawei continues to make progress on meeting its global sales goals. "Top management from France Telecom, British Telecom and Deutsche Telecom all visited Huawei in 2004, and they expressed a willingness to work with us," says Hu.

And in December Huawei announced that it had sold CDMA2000 network equipment to NTCH, which operates the Clear Talk mobile phone service. This allowed NTCH to add data service to its service areas in El Centro, Calif., and Yuma, Ariz. This was a change of vendor for NTCH, which had been buying its voice network equipment from Lucent. Glenn Ishihara, president of NTCH, says examining Huawei networks installed in other countries convinced his company of "the quality and cost-effectiveness of the Huawei system."

It was Huawei's first significant sale to a telecom carrier in the U.S., but it isn't likely to be the last. Says Ishihara: "We've gotten a lot of calls asking about working with Huawei."

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