TELECOMS: ZTE Settles with US, Looks Forward

Bottom line: ZTE’s settlement with the US over illegal sales to Iran will help the company focus on the future, as it advances with plans to move away from low-margin businesses and find more promising new growth areas.

After a year of living in a state akin to suspended animation amid a US probe against it for illegal sales to Iran, telecoms giant ZTE (HKEx: 763; Shenzhen: 000063) is finally seeing some light at the end of the tunnel, with word that it has finally reached a settlement in the matter. The company previously indicated the settlement would be no small deal, and the nearly $900 million fine it will have to pay proves that’s certainly the case.

But more important is the fact that ZTE has finally settled the case, meaning it can now get on with business without this major distraction hanging over its head. Before the settlement, ZTE had faced the possibility that it might get cut off from its key US suppliers as punishment for illegally selling US-made equipment to Iran in violation of earlier US sanctions against the country related to its nuclear program.

At the same time, ZTE has also conveniently provided some preliminary Q4 results that show a massive loss for the period, which looks related to this settlement. But it’s also telling us not to worry, adding that it expects to post healthy first-quarter profit growth now that the Iran matter is in the rearview mirror. That’s quite a bit of news to digest, and the net sum has given some positive upside to ZTE’s stock, which was up 5 percent in early trade in Hong Kong after the slew of announcements.

All that said, let’s kick off this flurry of information coming from ZTE with the settlement, which the company had previously indicated was coming soon. Now it’s saying it has agreed to plead guilty to the illegal sales activity, and pay a fine of $892 million as part of a comprehensive settlement. (company announcement) It’s also technically on the hook for another $300 million, though that part of the settlement is suspended for 7 years if ZTE complies with the settlement.

ZTE says the deal will have a “material impact” on its full-year 2016 results, and that’s indeed the case, based on the preliminary data it has just issued. Those results show the company expects to post a massive 2.4 billion yuan ($350 million) loss for all of 2016. (company announcement) When factoring in the company’s 2.2 billion yuan net profit for the first three quarters of last year, that translates to a whopping 4.6 billion yuan loss in the fourth quarter, equal to roughly $670 million.

Obviously that loss is due to the settlement, as ZTE clearly wants to put this matter behind it. The company adds that without that factor, it expects to report an operating profit of 1.16 billion for last year, which is up nearly 3 times from a year earlier. That comes even as revenue for the year grew by an anemic 1 percent, underlining that this is a company in transition as it spins off non-core businesses and scales back on marginal and money-losing ones.

Growing Profits

Last but not least, the company also gives us reason to be cautiously positive about the year ahead, reporting it expects its first-quarter profit to rise about 25 percent to between 1.15 billion yuan and 1.25 billion yuan. (company announcement) There’s no word in that announcement about expectation for first-quarter revenue, but based on the reports from last year, that figure will probably be up in the low single-digits.

So, what’s the bottom line in all this? My take is that this flurry of announcements show the worst could be behind for ZTE with the settlement of this potentially devastating US probe. The settlement also sends a strong message that Chinese companies need to behave more responsibly when trading in the global marketplace, and I expect ZTE will become a model corporate citizen going forward.

While that part of the story is in the rearview mirror, the company does still face the very real issue of near-zero revenue growth as it tries to figure out how to make competitive products the market wants. Its smartphones are still trying to find a niche both in China and abroad, and its older telecoms equipment business is also still mostly limited to less profitable developing markets.

But at least the growing operating profits is a positive sign, showing ZTE is slowing weaning itself off marginal businesses that lack strong future potential. The company has also said it’s on the hunt for global acquisitions, forming a nearly $1 billion pool for such purchases, and I expect we could see at least one or two major deals in promising new growth areas later this year.