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It's Time to Worry About China

Written by Briton Ryle
Posted March 13, 2018 at 8:00PM

So yesterday, President Trump signed an executive order blocking the widely discussed Broadcom takeover of Qualcomm. Section 1 of the order states:

There is credible evidence that leads me to believe that Broadcom Limited, a limited company organized under the laws of Singapore (Broadcom), along with its partners, subsidiaries, or affiliates, including Broadcom Corporation, a California corporation, and Broadcom Cayman L.P., a Cayman Islands limited partnership, and their partners, subsidiaries, or affiliates (together, the Purchaser), through exercising control of Qualcomm Incorporated (Qualcomm), a Delaware corporation, might take action that threatens to impair the national security of the United States... 

The issue here is not that Broadcom (NASDAQ: AVGO) is incorporated in Singapore. Last year, it moved its HQ back to Silicon Valley. Broadcom is truly a multinational. 

The concern that this merger poses a national security threat to the U.S. has more to do with what Broadcom won't do than what it will do. The Committee on Foreign Investment in the U.S. recommended the merger deal be blocked over concern that Broadcom would cut R&D spending at Qualcomm, thereby slowing American innovation for wireless chips right before the next generation of wireless gear (5G) gets deployed. 

Now, 5G isn't just a big deal. It's a huge deal. This is the wireless network that will be robust enough to support a whole network of autonomous vehicles. And you simply can't have "dropped calls" between cars doing 70 mph on the highway. Download speeds will be ridiculously fast. The Internet of Things (IoT) might actually take off. There will finally be viable alternatives to cable (damn you, Comcast!) for home broadband. 

And the U.S. doesn't want to see a Chinese company dominate the equipment sales that will make it all happen.

Spies Like Us

The U.S. and our European allies have long dominated innovation in technology. The current wireless standards and networks were agreed on and built by Intel, Cisco, Nokia, Ericsson, and yes, Qualcomm. 

But to paraphrase Saruman in The Two Towers, a new power is rising. And if the U.S. does nothing, its victory is at hand. Because two Chinese tech companies (ZTE and Huawei) are pushing very, very hard to enter and potentially dominate the next generation of wireless. A recent Bloomberg article says: 

ZTE Corp. filed for a record 4,123 patents through the PCT in 2016, the latest year for which figures are available, followed by Huawei Technologies Co. at 3,692. Third came Qualcomm, with 2,466.

Huawei is the big one, the one the U.S. should be most concerned about. 

Huawei is already the biggest cell phone maker in China, with a 20% market share. Add the other Chinese phone makers, and they command 66% of the Chinese market. Apple has about 8% and is the only foreign company to make the top 10. And that's fine. Except we know full well that China has long given preferential treatment to Chinese companies. 

In the fourth quarter of 2017, Huawei accounted for 32% of global wireless gear sales. Ericsson and Nokia accounted for 30% and 25%, respectively. And when it comes to 5G, Huawei has signed 25 memorandums of understanding (MoUs) to test equipment with the likes of British Telecom, Bell Canada (BCE), France’s Orange, Germany’s Deutsche Telekom, and global player Vodafone.

Now, Ericsson and Nokia have 38 and 31 MoUs, respectively. But still, Huawei is quickly becoming a very significant global player. And it's committed to spending $800 billion on 5G R&D this year...

Last month, the U.S. Senate introduced a bill that would ban Huawei from building any U.S. government networks due to the potential for spying. Most network operators do pretty extensive testing and don't seem concerned about the spying angle. Still, seems to me it's a good time for the U.S. to take the competitive threat to many of our tech companies seriously.

Wireless, AI, and Marijuana

In the U.S., we tend to think that, since we lead tech innovation now, it will stay that way. That's a dangerous frame of mind. Rest on your laurels for too long, and you lose your edge. Like how the American steel industry lost its edge...

After WWII, German and Japanese steel was basically nonexistent. The U.S. was making close to 75% of the world's steel. 

But Europe started building steel plants based on a new technique: the basic oxygen process. Bloomberg says building steel mills for the basic oxygen process "was 40%- 50% cheaper than conventional open-hearth factories; operating costs were 25 percent lower"; and output was four times greater. 

Europe built basic oxygen factories throughout the 1950s, while U.S. companies stuck with the less-efficient open-hearth method. Europe and Japan started using the electric arc method, too. American steel companies stuck to their guns and lost the global steel market. The first electric arc factory wasn't built in the U.S. until 1969 by a company that would eventually become Nucor. 

The U.S. blew it on steel. And there are a couple other areas that could go the same way, because China is focused on being #1 at something... like maybe artificial intelligence (AI). 

Chinese government policy fosters innovation in AI. They expect to catch up to existing tech by 2020 and be the global leader by 2030. 

Now, I'm not saying I want the U.S. government to be actively investing in AI R&D. But a spokesman for OpenAI recently told the New York Times: “We may have a bunch of small initiatives inside the government that are doing good, but we don’t have a central national strategy. It is confusing that we have this technology of such obvious power and merit and we are not hearing full-throated support, including financial support.”

And a recent MIT Technology Review cited reduced funding for fields including AI and tightening of rules on immigration for international researchers as potential problems. This at a time when China is planning a $2 billion technology park for AI in Beijing. 

Again, I'm not saying the U.S. will inevitably lose its lead in AI and that only the government can fix it. But there's no reason to stand in the way. Consider the market for marijuana right now. Recreational use is coming to Canada this July. Leading biotechs using cannabis for new drugs are British and European. 

Meanwhile, here in the U.S., we have a backwater attorney general who equates weed with heroin and a system that won't grant research applications for medicinal marijuana study. Heck, companies that legally sell marijuana can't even get bank funding. You ever wonder why the best marijuana stocks are Canadian? 

The U.S. is poised to miss out on being a leader in the burgeoning marijuana sector that could generate $50–$100 billion in annual revenue. Great. 

Let's hope we don't blow it in wireless and AI, too.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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