In the aftermath of ZTE Corp.’s violation of U.S export laws, the U.S. commerce department has barred the American suppliers from providing components to ZTE for seven years.
ZTE Corp. (SZSE:000063, Financial) violated the U.S. export laws last year by providing technology equipment to Iran, which is under trade sanctions from the U.S. ZTE is expected to pay a total of $1.2 billion in fines. Note that ZTE is the second largest telecom equipment provider to China.
U.S.-based companies provide around 30% of the components used by ZTE in networking equipment and smartphones. Several big names are among the affected, including Qualcomm (QCOM), Acacia (ACIA, Financial), Lumentum (LITE, Financial) and Oclaro (OCLR, Financial).
MACOM technology (MTSI, Financial) also generates some of its revenue from sales to ZTE. Huawei (SZSE:002502) and Nokia (NOK, Financial) are set to benefit from gaining market share in 100+G optical transceiver market. Lumentum is also not affected much due to its low exposure to ZTE.
*Lumentum is exposed 10% due to its potential acquisition of Oclaro
In optical networking, ACIA Communications Inc. will take the hardest blow, as the company generated around 30% of its revenue from ZTE during the year ended 2017. The stock is down 35% since the news.
Oclaro is also among the materially affected, as it is set to lose more than 15% of its revenue. The company generated 18% of its revenue from ZTE during the year-ended 2017. Huawei and Nokia made up 15% and 12% of the revenue of Oclaro during the same period.
Although Lumentum didn’t have much exposure to ZTE in the past, the company is now exposed due to its recent acquisition of Oclaro. The deal was not looking so good for Oclaro’s investors before the ZTE ban. Now it seems that Lumentum is at a loss. The company generated more than 16% of its revenue from Huawei. With Oclaro, ZTE’s contribution would have amounted to 10%. Lumentum is set to lose more than 100 million in revenue as a result of Oclaro’s acquisition.
MACOM is largely unaffected by the ban on ZTE, thanks to its diverse customer base. The top 25 direct customers of the company generated around 60% of the revenue during the year ended 2017. In responding to the ban, the management of MACOM noted that ZTE sales were immaterial to the total revenue as the sales for the most recent quarter amounted to $1.8 million. This translates to annualized sales of $7.2 million, making up around 1% of the company’s total revenue.
It is unclear to what extent Finisar (FNSR, Financial) is affected. The company didn’t disclose the amount of sales to ZTE. The sales are less than 10%, though, as no customer other than Huawei makes up 10% of Finisar’s revenue.
What are the key takeaways?
The reaction is overdone, as demand remains intact.
Although optical networking companies are losing ZTE business, demand for optical networking gear is not expected to go down. Customers are expected to turn to Huawei and Nokia for optical products due to unavailability of the cutting edge technology at ZTE going forward. As Nokia and Huawei are going to pick up pace, especially in the 100G+ market, component suppliers’ sales will shift towards Huawei and Nokia.
Note that optical network component providers including, among others, Lumentum, Oclaro and Finisar already supply components to Huawei and Nokia. The reduction in revenue from ZTE will be offset by additional demand coming from Huawei and Nokia.
Optical networking component margins will come under pressure.
ZTE’s exit from the American business means a shift of pricing power towards equipment manufacturers including Huawei and Nokia. They will be able to charge more due to additional demand and pay less to the component suppliers. In short, margins of network component suppliers are expected to come under pressure going forward.
Consolidation may come into play.
As price power shifts towards network gear providers, a consolidation on the component side is imminent. Lumentum has already agreed to a deal with Oclaro. Other component providers may follow suit in order to maintain the pricing power in the industry.Â
Other network gear manufacturers and related suppliers are expected to benefit.
Although the ban on ZTE is bad news for optical networking component suppliers in general, most of the negative effect will be offset by rising demand from other suppliers. Nonetheless, margins will come under pressure. Due to the recent sell-off, component suppliers with exposure to Huawei and Nokia are looking attractive amid potential business coming from Huawei and Nokia.
The sell off of optical companies is overdone because demand isn’t affected due to ZTE’s ban. However, margin pressure will come into play to affect network component providers negatively. Consolidation in the industry might be needed to offset the pricing power imbalance.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.