Huawei's interesting 2019 results

Huawei is looking down the barrel of a change in the US Entity List regulations which could cut it off from Taiwan’s TSMC, its primary fab. The details are still unclear, but the in-coming change in US law may mean that Huawei can no longer manufacture the leading edge chips it designs and uses in its smartphones and 5G infrastructure at TSMC or, effectively, anywhere else in the world worth the mustard.

Much has been written about the impact so far of Entity Listing on Huawei (for e.g. here, on this very blog!). And there has been some discussion of what this rule-change may mean (though, since the details are still unknown it is of course hard to say – though my baseline expectation is that it will effectively cut off Huawei from leading-edge chips.)

This all makes Huawei’s 2019 financial results all the more interesting.

The relevant headlines have been reported elsewhere. All things considered, the results were pretty damn good. Revenues were up 19% yoy, the consumer business (mostly smartphones) was on fire, particulary in China. Profits rose 14%, so they didn’t “buy” all that topline growth with price cuts etc.. And Huawei’s operating margin of 9.1% was very much in line with recent history. So, while it may not have been that controversial, this all backs the judgement I made in that November 2019 blog (basically, “What doesn’t kill you, makes you stronger”.)

But I thought it might be interesting to dig into the 2019 financials to see if anything interesting (or weird) was going on beneath the headlines.

I found five things.

First, it’s the consumer business which is powering the Huawei beast right now. This chart shows revenues by business segment. Consumer is mostly smartphones, though there are PCs, tablets & wearables in there too. Smartphone sales were up 16% on the year, to 240mn units. Huawei took share from Apple and everyone else in China, even if sales in Europe were hit by the lack of Google’s GMS app package on the phones. Consumer is now 55% of total revenues, compared to 40% two years ago. Huawei’s carrier segment – 5G infrastructure like RAN – looks like it is stagnating. And the enterprise business which is private datacentres and Huawei cloud is growing much more slowly (and seems to sell mostly into government-related entities).

The issue is that if the revised Entity List rules prevent Huawei from manufacturing its Kirin 990 SoC chips (the key chip which makes its 5G phone sing) at TSMC, then that business is suddenly very vulnerable. (The FT had a nice teardown of that phone recently, and found Quorvo and Skyworks front-end RF components in there – and they’d be vulnerable too). Of course, who knows how badly that USD 67bn could fall this year – it’ll have been hit already by collapsing phone sales in Q1. But it could be very substantial.

With Beijing contemplating an accelerated 5G network rollout in H2 2020-2021 as part of a “smart stimulus” package, then Huawei’s carrier business should get a nice boost this year.

But then Beijing will face a quandary – if Huawei can’t produce 5G phones, what will people buy to use China’s all-bright-and-sparkly domestic 5G network? Apple? Or if Beijing decides to retaliate against the US for a painful Entity Listing move, does Apple get it in the back of the head? Does Xiaomi’s 5G offering suddenly get a boost? Watch this space.

Second, Huawei is squirrelling away cash, an increasing share of it borrowed. At the end of 2019, Huawei had cash (and cash equivalents, including wealth management products and securities) of USD 53bn. A large chunk of that cash is theirs (to which I’ll come back to below).

But a growing share is borrowed. Huawei had bank loans and bonds outstanding totalling USD 16bn at year-end, up 60% on the year. Borrowing more is not classic “de-risking a balance sheet” behaviour. Firms fearing heavy weather ahead sometimes pay down their debt, just in the bank calls in the loan just when they need it. But in Huawei’s case, I doubt they worry very much about angry bank managers. So they’ve clearly decided to boost avaiable liquidity in case of trouble ahead. For things like paying staff in case the smartphone business goes AWOL.

Most of this new borrowing is in renminbi (as well as Hong Kong dollars) and most of it is long-term bank loans, one- to five-years. There was talk of China Development Bank (CDB) offering them a substantial facility. There’s no detail about the total size of Huawei’s agreed bank facilities or who its banks are these days, but that is the kind of thing CBD would do. The interest rate on the renminbi loans does not appear to be wierdly low; it’s reported as 4.28-4.75%.

Third, there was a big increase in inventories. At the end of 2019, Huawei was holding USD 24bn worth of inventories, compared to USD 14bn the year before, and UDS 10bn in 2017. As a share of revenue, that’s up to 20%, from 12-13% in previous years. Now, this is going to be a mix of components Huawei has bought in anticipation of being cut off from its key suppliers, as well as kit it’s bulit but has been unable to sell. The later will have ballooned in Q1 this year, given COVID-19 and the collapse of smartphone sales, but last year, my guess is that the majority of that USD 24bn are those key components. That’s a very sizeable extra spend in 2019, and would have padded the results of Huawei’s key suppliers. But it may mean that Huawei can indeed weather the first few months of a revised Entity listing. Again, watch this space.

Fourth, there’s the small matter of tax. Huawei paid an effective rate of 13% in corporate income tax last year, with a substantial deferral into future years. That compares with 16% in 2018-17.

Fifth, and final, interesting thing: what it has been doing with its profits.

Huawei made some USD 9bn last year in post-tax profits. I’m told that Huawei employees traditionally get compensated in three ways: a base salary, a time-based unit plan (TUP) based on performance, and (it’s an employee-owned company, after all!), a share of the post-tax profits for those lucky-enough to own ‘equity’ (or, if not equity, then at least something which gives them the right to get paid a share of the profits).

(I’m making no comment here on the fabled “shareholder ledger” held in that glass-case at Huawei Shenzhen’s HQ, or on the question of control. Just because profits are distributed to senior employees does not put them in de facto control of the firm.)

Here’s those three line items. The TUP is not that significant.

But, of course, Huawei does not have to distribute those post-tax profits to its employee/shareholders – the board can chose not to distribute dividends and keep the cash on the balance sheet for a rainy day. And this is, I suspect, what has been happening in the last couple of years.

This is what my last chart attempts to show. I’ve calculated the change in Huawei’s net cash position each year (i.e. its cash and other investments minus its borrowings). That amounts to USD 37bn rattling around in its pocket at year end 2019, a USD 9bn increase on 2018. That number is surprisingly close to the firms’ post-tax profits in 2019 – USD 9bn. In 2015-16, all of the net profits seemed to be distributed (as employee compensation, I guess) but since 2017, it looks like a good chunk has been retained.

This is what a firm preparing just not for a rainy day, but a thunderstorm, would do. Why 2017? In March 2016 ZTE was Entity-Listed – and from that point on Huawei I bet was just counting the days until it would happen to them too.

If I’m right about this, then I wonder about senior employee retention. I don’t know how many Huawei employees used to get paid a substantial dividend. But back in the good ole days, that would have been seen as part and parcel of total comp (maybe even 30-50% of a senior package), as what attracted you to Huawei.

If they’re now hunkered down and “just” getting paid a salary and TUP, then maybe their dedication to the firm, and the country, keeps them there for a while. But if this was the third year seniors didn’t receive a share of the profits then I wonder how much longer they’ll stay.

Particularly if in H2 2020-21 Huawei’s cash-cow smartphone business suffers a double-hit: COVID-19 and the US Entity listing rules changing.